Chapter 26: Q12SE (page 1467)
Refer to the Hunter Valley Snow Park Lodge expansion project in Short Exercise S26- 4. What is the project’s NPV (round to nearest dollar)? Is the investment attractive? Why or why not?
The investment is attractive and the net present value is$2,523,232.
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Use the Present Value of \(1 table (Appendix A, Table A-1) to determine the present value of \)1 received one year from now. Assume a 8% interest rate. Use the same table to find the present value of \(1 received two years from now. Continue this process for a total of five years. Round to three decimal places.
Requirements
1. What is the total present value of the cash flows received over the five-year period?
2. Could you characterize this stream of cash flows as an annuity? Why or why not?
3. Use the Present Value of Ordinary Annuity of \)1 table (Appendix A, Table A-2) to determine the present value of the same stream of cash flows. Compare your results to your answer to Requirement 1.
4. Explain your findings.
Using accounting rate of return to make capital investment decisions
Carter Company is considering three investment opportunities with the following accounting rates of return:
Project X | Project Y | Project Z | |
ARR | 13.25% | 6.58% | 10.47% |
Use the decision rule for ARR to rank the projects from most desirable to least desirable. Carter Company’s required rate of return is 8%.
Why is it preferable to receive cash sooner rather than later?
Hamilton Company is considering two capital investments. Both investments have an initial cost of \(7,000,000 and total net cash inflows of \)16,000,000 over 10 years. Hamilton requires a 20% rate of return on this type of investment. Expected net cash inflows are as follows:
Year | Plan Alpha | Plan Beta |
1 | \(1,600,000 | \)1,600,000 |
2 | \(1,600,000 | 2,200,000 |
3 | \)1,600,000 | 2,800,000 |
4 | \(1,600,000 | 2,200,000 |
5 | \)1,600,000 | 1,600,000 |
6 | \(1,600,000 | 1,500,000 |
7 | \)1,600,000 | 1,300,000 |
8 | \(1,600,000 | 1,100,000 |
9 | \)1,600,000 | 900,000 |
10 | \(1,600,000 | 800,000 |
Total | \)16,000,000 | \(16,000,000 |
Requirements
1. Use Excel to compute the NPV and IRR of the two plans. Which plan, if any, should the company pursue?
2. Explain the relationship between NPV and IRR. Based on this relationship and the company’s required rate of return, are your answers as expected in Requirement 1? Why or why not?
3. After further negotiating, the company can now invest with an initial cost of \)6,500,000. Recalculate the NPV and IRR. Which plan, if any, should the company pursue?
Mountain Manufacturing is considering the following capital investment proposals. Mountain’s requirement criteria include a maximum payback period of five years and a required rate of return of 12.5%. Determine if each investment is acceptable or should be rejected (ignore qualitative factors). Rank the acceptable investments in order from most desirable to least desirable
Project | A | B | C | D | E |
Payback | 3.15 years | 4.20 years | 2.00 years | 3.25 years | 5.00 years |
NPV | \(10,250 | \)42,226 | (\(10,874) | \)36,251 | $0 |
IRR | 13.0% | 14.2% | 8.5% | 14.0% | 12.5% |
Profitability index | 1.54 | 1.92 | 0.75 | 2.86 | 1.00 |
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