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Chapter 09

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I.

Questions

1.

A hotel may consider buying an item of equipment with a rapid payback rather

than one with a high average rate of return if

a)

its money being tied up in an investment for a relatively long period of

time.

b) Management believes that the equipment can be subjected to rapid

obsolescence.

c) The company has obtained a loan to finance the equipment and it wants

to repay the principal right away to avoid financing costs.

2.

The money is worth more now than that same amount of money a year from

now.

3.

If the cash outlay today is P10,000 and the present value of the total cash returns

were P9,500, one should not make the investment because this means that the

investment will not yield the desired return on investment. For the project to be

acceptable, the present value of the returns should at least be equal to the present

value of the investment.

4.

Net Present Value is the excess of the present value of cash inflows generated by

the project over the amount of the initial investment. This is computed as

follows:

Present value of cash inflows computed based

on minimum desired discount rate

Less: Present value of investment

Net Present Value

Pxx

xx

Pxx

Discounted Rate of Return, also known as internal rate of return (IRR) and timeadjusted rate of return, is the rate which equates the present value of the future

cash inflows with the cost of the investment which produces them. It is also the

equivalent maximum rate of interest that could be paid each year for the capital

employed over the life of an investment without loss on the project.

If an independent project is being evaluated, then the NPV and IRR criteria

always lead to the same accept/reject decision.

9-2

especially those that differ in scale (project size) and/or timing, a conflicts of

ranking may arise. That is, the IRR method may favor one alternative over

another while the NPV method may indicate otherwise. If conflicts arise, the

NPV method should be used. The NPV method assumes the cash flows will be

reinvested at the firms cost of capital while the IRR method assumes

reinvestment at the projects IRR. Because reinvestment at the cost of capital is

generally a better (closer to reality) assumption, the NPV is superior to the IRR.

5.

Comparison between the cash flows from operations before and after the

landscaping is done may be made. The purpose of the investment is to make the

resort more attractive to patrons and guests. Hence, when more resources are

generated after the investment is made, it is an indication that the decision has

been beneficial to the company.

Negative NPV would generally indicate that the investment proposal is not

acceptable because the desired rate of return is not attainable. It does not mean

however that the project will be unprofitable. Therefore if the prospective

investor is willing to accept a lower rate of return, then the project may become

acceptable.

A. EXERCISES

EXERCISE 1

Requirement (a)

Payback period:

Machine A

P25,800

P5,940

Machine B

=

4.34 yrs.

P24,200

P7,800

3.10 yrs.

Requirement (b)

Yes. Machine B. It is the more preferable investment because the recovery period of

capital is shorter.

9-3

EXERCISE 2

Repayment schedule:

End of Year

0

1

2

3

4

5

Principal

Payment

Interest

Total

4,500

4,500

4,500

4,500

4,500

2,250

1,800

1,350

900

450

6,750

6,300

5,850

5,400

4,950

Balance

of Principal

22,500

18,000

13,500

9,000

4,500

0

B. PROBLEMS

PROBLEM 1

Relevant Data

Investment required

Cash flows from

operations

and equipment

Net Present Value

End of

Period

0

Amount

PVf at 13% Present Value

P(205,000)

1.000

P(205,000)

1

2

3

4

5

37,500

43,800

46,300

50,000

60,000

0.885

0.783

0.693

0.613

0.543

33,188

34,295

32,086

30,650

32,580

18,500

0.543

10,046

P(32,155)

The prospective investor should not make the investment because it would not yield

the desired rate of return of 13%. The negative net present value as shown in the

computation indicates that the internal rate of return is lower than 13%.

Through Trial Computations, the IRR can be determined as follows:

0

1

2

3

4

5

5

Trial at 6%

Cash In (Out) Flow

Amount

PVf

PV

(205,000)

1.000

(205,000)

37,500

0.943

35,263

43,800

0.890

38,982

46,300

0.840

38,892

50,000

0.792

39,600

60,000

0.747

44,820

18,500

0.705

13,042

5,599

Trial at 8%

Cash In (Out) Flow

Amount

PVf

PV

(205,000)

1.000

(205,000)

37,500

0.926

34,725

43,800

0.857

37,537

46,300

0.794

36,762

50,000

0.735

36,750

60,000

0.681

40,860

18,500

0.681

12,599

(5,767)

9-4

To get the Internal Rate of Return closest to the exact rate, interpolation may be

applied as follows:

IRR

6% +

5,599 0

5,599 (5,767)

6% +

5,599

11,366

6% + 0.98%

6.98%

x 2%

x 2%

Proof: Using 6.98% as the discount rate, the net present value will be as follows:

End of Year

0

1

2

3

4

5

5

Amount

P(205,000)

37,500

43,800

46,300

50,000

60,000

18,500

Net Present Value

PVf at 13%

1.000

0.935

0.873

0.816

0.763

0.714

0.714

PROBLEM 2

Requirement (a)

Payback Period:

Alternative 1

Year

Annual CF

1

2

3

4

5

4,200

5,800

8,500

11,500

12,000

Cumulative

CF

4,200

10,000

18,500

30,000

42,000

Present Value

P(205,000)

35,063

38,237

37,781

38,150

42,840

13,209

P

280 *

9-5

Payback Period

=

4 years +

4.42 years

35,000 30,000

12,000

1 year

Alternative 2

Year

Annual CF

1

2

3

4

12,100

9,900

8,900

5,400

Cumulative

CF

12,100

22,000

30,900

36,300

Payback Period

=

3 years +

3.76 years

35,000 30,900

5,400

1 year

Requirement (b)

Net Present Value 10% discount rate

Relevant Data

Investment

Cash Inflows

End of

Year

0

1

2

3

4

5

Net Present Value

Amount

P(35,000

)

4,200

5,800

8,500

11,500

12,000

Alternative 1

PVf

PV

1.000 P(35,000

)

0.909

3,818

0.826

4,791

0.751

6,384

0.683

7,855

0.621

7,452

P (4,700)

Amount

P(35,000

)

12,100

9,900

8,600

5,400

4,000

Alternative 2

PVf

PV

1.000 P(35,000

)

0.909

10,999

0.826

8,177

0.751

6,459

0.683

3,688

0.621

2,484

P (3,193)

No. Both alternatives would not yield the desired rate of return of 10%.

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