Problem-1 (Net present value method with income tax)

A mining company is considering to open a new coal mine. The company has collected the following information about
the cash flows associated with this project:

Equipment needed for new mine: $900,000

Working capital required for new mine: $210,000

Expected annual cash inflow from the sale of coal: $750,000

Expected annual cash expenses associated with the new mine: $500,000

Road repairs required after 5 years: $110,000

The coal in the mine would be exhausted after 15 years. The equipment would be sold for its salvage value of $250,000
at the end of 15-year period. The company uses straight line method of depreciation and does not take into account the
salvage value for computing depreciation for tax purpose. The tax rate of the company is 30%.

Required:

Compute net present value (NPV) of the new coal mine assuming a 15% after-tax cost of capital.

On the basis of your computations in requirement 1, conclude whether the coal mine should be opened or not.

Solution:

(1) Computation of net present value:

*Value from “present value of an annuity of $1 in arrears table“.

**Value from “present value of $1 table”.

Problem-2 (Net present value analysis – handling working capital)

The Universal Trading Company has obtained a license to introduce a new product for 6 years. The product would be
purchased from manufacturing company for $10 per unit and sold to customers for $20 per unit. The estimated annual
cash expenses to sell the new product would be $18,000. Other information associated with the new product is given
below:

Cost of equipment needed: $30,000

Working capital needed: $40,000

Repairs and maintenance of equipment after 5 years: $2,500

Residual value of equipment after 6 years: $5,000

The working capital would be released at the end of 6-year period. The expected annual sales are 5,000 units of product.
The discount rate of the company is 16%.

Required:

Compute net present value (NPV) of the new product. (Ignore income tax).

Would you recommend the addition of new product?

Solution:

(1) Net present value (NPV) of new product:

*Value from “present value of an annuity of $1 in arrears table“.

**Value from “present value of $1 table”.

Problem-3 (discounted payback period method)

SK Manufacturing Company uses discounted payback period to evaluate investments in capital assets. The company
expects the following annual cash flows from an investment of $3,500,000:

No salvage/residual value is expected. The company’s cost of capital is 12%.

Required:
Compute discounted payback period of the investment.
Is the investment desirable if the required payback period is 4 years or less.
Solution:
(1) Computation of discounted payback period:
In order to compute the discounted payback period, we need to compute the present value of each year’s cash flow.

Discounted payback period = Years before full recovery + (Unrecovered cost at start of the year/Cash flow during the
year)
= 5 + (**$255,500/$456,300)
= 5 + 0.56
= 5.56 years
*Value from “present value of $1 table”.
**Unrecovered cost at start of 6th:
= Initial cost – Cumulative cash inflow at the end of 5th year
= $3,500,000 – $3,244,500
= $255,500

Problem-4 (Preference ranking of investment projects)

The Martin Company is considering the four different investment opportunities. The selected information
about each proposal is given below:

The present value of cash inflows given above have been computed using a 10% discount rate. The
company is unable to accept all available projects because the funds available for investment are limited.
Required:
Compute the profitability index (present value index) for all the projects.
Rank the four investment projects according to preference using:
(a). net present value (NPV).
(b). profitability index (PI).
(c). internal rate of return (IRR).
Which one is the best approach for Martin Company to rank five competing projects?
Solution:
(1). Computation of profitability index:
Formula of profitability/present value index is:
Profitability index = Present value of cash inflows/Investment required
Project 1: $1,134,540/$960,000 = 1.18
Project 2: $866,800/$720,000 = 1.20
Project 3: $672,280/$540,000 = 1.24
Project 4: $1,045,490/$900,000 = 1.16
Project 5: $759,520/$800,000 = 0.95
(2) Preference ranking of projects:

3. The best ranking approach:

The best method of ranking projects depends on the availability of good reinvestment opportunities. Under
internal rate of return (IRR) method, we assume that the funds released from a project are reinvested in
another project yielding the internal rate of return equal to the previous project. According to IRR, the
project 4 is ranked at number one with 19% IRR. It means any funds released from project 4 must be
reinvested in another project yielding an internal rate of return of at least 19% but It might be difficult to
find a project with such a high IRR.
The profitability index (PI) shows the present value of cash inflow generated by each dollar invested in a
project. It assumes that the funds released from a project are reinvested in another project with a return
equal to the discount rate. In our problem, the discount rate is only 10%. Generally, the profitability index
is considered the most dependable method of ranking competing projects.
The net present value (NPV) method considers the net present value figure but does not take into account
the amount of investment required for the project. Therefore, this method is not appropriate for comparing
or ranking competing projects that require different amounts of investment.  For example, project 3 is
ranked at number four because of its low net present value but it is the best option if we see at the present
value of net cash inflow generated by each dollar invested in the project (as shown by the profitability
index).

Problem-5 (Internal rate of return and net present value methods)

Net present value method:
Sunlight company needs a machine for its manufacturing process. The cost of the new machine is
$80,700. The expected useful life of the machine is 8 years. At the end of 8-year period, the machine
would have no salvage value. After installation, the machine would increase cash inflows by $30,000 per
year. Sunlight is interested to know the net preset value of the machine to accept or reject this investment.
The minimum required rate of return of the company is 16% on all capital investments.
Required:
Compute net present value of the machine.
Is it acceptable to purchase the machine?
Solution:
 (1) Net present value computation:

* Value from “present value of annuity of $1 in arrears table“.

(2) Purchase decision:
The positive net present value (computed above) indicates that the investment is profitable, therefore the
machine should be purchased.
Internal rate of return method:
A machine can reduce annual cost by $40,000. The cost of the machine is 223,000 and the useful life is
15 years with zero residual value.
Required:
Compute internal rate of return of the machine.
Is it an acceptable investment if cost of capital is 16%?
Solution:
(1) Internal rate of return (IRR) computation:
Internal rate of return factor = Net annual cash inflow/Investment required
= $223,000/$40,000
= 5.575
Now see internal rate of return factor (5.575) in 15 year line of the present value of an annuity if $1 table.
After finding this factor, see the corresponding interest rate written at the top of the column. It is 16%.
Internal rate of return is, therefore, 16%.
Problem-6 (Capital budgeting/NPV with inflation)
Delta company manufactures silicon boards that are used in preparing small, medium and large size
electronic circuits. The company is considering to reduce its cost by automating some of its manufacturing
tasks. This automation requires the installation of a new equipment. The relevant information for net
present value (NPV) analysis of investment in new equipment is given below:

 Cost of equipment: $72,000

 Expected annual cost savings to be provided by new equipment: $40,000
 Useful life of the equipment: 6 years
 Salvage value at the end of 6 years: $0
 Cost of capital: 23.2%
 Expected inflation rate in cash flows associated with the new equipment: 10%

Required:

1. What would be the net present value (NPV) of new equipment if:

(a). the inflation is considered?
(b). the inflation is not considered?
2. Should the new equipment be purchased?

Solution:
(1) Computation of net present value:

a. If inflation is not considered:

In this problem, we are given the nominal discount rate of 23.2%. In order to compute NPV without
considering inflation, the first step is to compute the real discount rate. It can be computed by using the
following formula:

Real discount rate = (Nominal discount rate – Inflation rate) ÷ (1 + Inflation rate)

= (23.2% – 10%) ÷ (1 + 10%)

= (13.2%) ÷ 1.1

= 12%

The real discount rate is 12% and has been used in the following computations.
* Value from “present value of an annuity of $1 in arrears table“.

b. If inflation is considered:

*(1 + inflation rate)n

**1/(1 + i)n

The net present value computed with and without inflation should be the same. The difference of $37
($92477 – $92,440) in NPV figure computed under two approaches is due to rounding error.

Problem-7 (Net present value analysis – total and incremental cost

approach)
The National Transport Company has a number of large trucks. One of the trucks is in poor condition and
needs an immediate renovation at a cost of $100,000. An overhaul of engine will also be needed 6-years
from now at a cost of $10,000. If theses costs are incurred, the truck will be useful for 12 years. After 12-
year period, it will be sold at a salvage value (scrap value) of $30,000. At this time, the salvage value of
the truck is $35,000. The total annual revenues of the truck will be $200,000 and the total cost to operate
the truck will be $150,000 per year.

Alternatively, National Transport Company can purchase a new truck for $180,000. The new truck will
require some repairs at the end of 6-year period at a cost of $5,000. Its salvage value will be $30,000 after
its useful life of 12 years. The total annual revenues of the new truck will be $200,000 and its operating
cost will be $110,000 per year.

The company’s required rate of return is 15% before taxes.

Required: Should National Transport Company renovate the old truck or purchase a new truck. Use the
following approaches to net present value (NPV) analysis for your answer:

1. Total cost approach.

2. Incremental cost approach.
(Ignore income tax in your computations.)

 Solution:
(1) Total cost approach to NPV:

* Value from “present value of an annuity of $1 in arrears table“.

**Value from “present value of $1 table”.

Net present value in favor of buying the new truck:

 NPV with new truck – NPV with old truck

= $346,340 – $172,340

= $174,000

Since the NPV of new truck surpasses the NPV of old truck by $174,000, the company should buy the
new truck rather than renovating the old one.

(2) Incremental cost approach to NPV:

* Value from “present value of an annuity of $1 in arrears table“.

**Value from “present value of $1 table“.