Demonstration Problem

Chapter 16 – Exercise 17

Calculate NPV – Compare to IRR

AccountingWhat the Numbers Mean 9e

Problem Definition

• Sun Bay Manufacturing, Ltd. Is considering the investment of $230,000 in a new machine. The machine will generate cash flow of $40,000 per year for each year of its eight-year life and will have a salvage value of $26,000 at the end of its life. The company’s cost of capital is 10%.

Problem Requirements

a. Calculate the net present value of the proposed investment. (Ignore income taxes.)

b. What will the internal rate of return on this investment be relative to the cost of capital? Explain your answer.

Problem Solution

a. Calculate the net present value of the proposed investment. (Ignore income taxes.)

Set up a model for analyzing the timing of cash flows and enter all cash flows generated

by this project.

• Model for analyzing project cash flows:

Problem Solution

Solution Steps:Step 1 – Setup the project years and cash flow items.

• Model for analyzing project cash flows:

Problem Solution

Solution Steps:Step 1 – Setup the project years and cash flow items.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment

Solution Steps:Step 1 – Setup the years and cash flow items.

Solution Steps:Step 1 – Setup the project years and cash flow items.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment Annual cash flow

Solution Steps:Step 1 – Setup the years and cash flow items.

Solution Steps:Step 1 – Setup the project years and cash flow items.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment Annual cash flow Salvage value

Solution Steps:Step 1 – Setup the years and cash flow items.

Solution Steps:Step 1 – Setup the project years and cash flow items.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

InvestmentAnnual cash flow Salvage value

Solution Steps:Step 2 – Enter all cash flow amounts.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment $(230,000)Annual cash flow Salvage value

Solution Steps:Step 2 – Enter investment amount.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment $(230,000)Annual cash flow $40,000Salvage value

Solution Steps:Step 2 – Enter annual cash flow amount.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment $(230,000)Annual cash flow $40,000Salvage value $26,000

Solution Steps:Step 2 – Enter salvage value amount.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment $(230,000)Annual cash flow $40,000Salvage value $26,000

Solution Steps:Step 3 – Calculate the present value of the cash flows.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment $(230,000)Annual cash flow $40,000Salvage value $26,000

Present Value:

$(230,000)Solution Steps:Step 3 – Calculate the present value of the cash flows.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment $(230,000)Annual cash flow $40,000Salvage value $26,000

x 5.3349Present Value:

$(230,000) 213,396 PV factor – Table 6-5:

8 period row, 10% column

Solution Steps:Step 3 – Calculate the present value of the cash flows.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment $(230,000)Annual cash flow $40,000Salvage value $26,000

x 5.3349 x .4665Present Value:

$(230,000) 213,396 12,129 PV factor – Table 6-4:

8 period row, 10% column

Solution Steps:Step 3 – Calculate the present value of the cash flows.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment $(230,000)Annual cash flow $40,000Salvage value $26,000

x 5.3349 x .4665Present Value:

$(230,000) 213,396 12,129

Solution Steps:Step 4 – Calculate the net present value of the proposed investment.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment $(230,000)Annual cash flow $40,000Salvage value $26,000

x 5.3349 x .4665Present Value:

$(230,000) 213,396 12,129 $ (4,475)

Net Present Value

Solution Steps:Step 4 – Calculate the net present value of the proposed investment.

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

• Model for analyzing project cash flows:

Problem Solution

Investment $(230,000)Annual cash flow $40,000Salvage value $26,000

x 5.3349 x .4665Present Value:

$(230,000) 213,396 12,129 $ (4,475)

Solution:Since the NPV is negative, the investment does not earn the 10% cost of capital. Net Present Value

Year: 0 – 1 – 2 – 3 – 4 – 5 – 6

Problem Requirements

a. Calculate the net present value of the proposed investment. (Ignore income taxes.)

b. What will the internal rate of return on this investment be relative to the cost of capital? Explain your answer.

Problem Solution

Because the net present value is negative, the internal rate of return on this project will be lower than the cost

of capital of 10%.

AccountingWhat the Numbers Mean 9e

David H. MarshallWayne W. McManus

Daniel F. Viele

You should now have a better understanding ofnet present value and internal rate of return.

Remember that there is a demonstration problem for each chapter that is here for your learning benefit.