Problem 16-19 Using net present value and internal rate of return to evaluate investment opportunities

Pedro Spier, the president of Spier Enterprises, is considering two investment opportunities. Because of limited resources, he will be able to invest in only one of them. Project A is to purchase a machine that will enable factory automation; the machine is expected to have a useful life of four years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $200,000 and for Project B are $80,000. The annual expected cash inflows are $63,000 for Project A and $26,400 for Project B. Both investments are expected to provide cash flow benefits for the next four years. Spier Enterprises' cost of capital is 8 percent.

Required

a.Compute the net present value of each project. Which project should be adopted based on the net present value approach? Round your computations to two decimal points.

b.Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach? Round your rates to six decimal points.

c.Compare the net present value approach with the internal rate of return approach. Which method is better in the given circumstances? Why?

Acct 301 Week 7 Sample Problem Problem #1 Using Present Value Techniques to evaluate alternative investment opportunities Classic Delivery is a small company that transports business packages between Philadelphia and Dallas. It operates a fleet of small vans that moves packages to and from a central depot within each city and uses a common carrier to deliver the packages between the depots in the two cities. Classic Delivery recently acquired approximately $ 8 million of ca capital from its owners, and its president, Mary Clark, is trying to identify the most profitable way to invest these funds. Larry Edwards, the company's operations manager, believes that the money should be used to expand the fleet of city vans at a cost of $ 830,000. He argues that more vans would enable the company to expand its services into new markets, thereby incre the revenue base. More specifically, he expects cash inflows to increase by $295,000 per year. The additional vans are expected useful life of four years and a combined salvage value of $90,000. Operating the vans will require additional working capital of $ 50,000, which will be recovered at the end of the fourth year. In contrast, Martha Lanes, the company's chief accountant, believes that the funds should be used to purchase large trucks to deliver the packages between the depots in the two cities. The conversion process would produce continuous improvement in savings and reduce cash outflows as follows: Year 1 Year 2 Year 3 Year 4 $ 180,000 $ 320,000 $ 400,000 $ 420,000 The large trucks are expected to cost $ 890,000 and to have a four-year useful life and a $ 70,000 salvage value. In a to the purchase price of the trucks, up-front training costs are expected to amount to $ 21,000. Classic Delivery's management has established a 8 percent desired rate of return. Required: Round your computations to two decimal places: a. Determine the net present value of the two investment alternatives. b. Calculate the present value index for each alternative. c. Indicate which investment alternative you would recommend. Explain your choice. Part A Alternative 1 Cash Inflows Annual cash inflows Salvage Value Working Capital Recovery Total Cash Inflows Cash Outflows Cost of Vans $ 295,000 90,000 Table Value 3.312127(1) 0.735030(2) Present Value $ 977,077.47 66,152.70 50,000 0.735030(2) 36,751.50 $ 1,079,981.67 (830,000.00) Working Capital Increase Net Present Value (1) Table 2, n=4 years r= 8% (2) Table 1, n= 4 years, r =8% (50,000.00) $ 199,981.67 Altenative 2 Cash Inflows Year 1 Year 2 Year 3 Year 4 $ Salvage Value Total Cash Inflow Cash Outflows Cost of Trucks 180,000 320,000 400,000 420,000 Table Value 0.925926(1) 0.857339(2) 0.793882(3) 0.793882(4) Present Value $ 166,666.68 274,348.48 317,552.80 333,430.44 70,000 0.793882(4) 55,571.74 $ 1,147,570.14 (890,000.00) Training Cost Net Present Value $ (21,000.00) 236,570.14 (1) Table 1, n=1, r=8% (2) Table 1, n=2, r=8% (3) Table 1, n=3, r=8% (4) Table 1, n=4, r=8% Part B Alternative 1: Present Value of Cash Inflows Present Value of Cash Outflows $ $ 1,079,981.67 880,000.00 (Sum of Cash Outflows-Alternative 1) 1.23 Alternative 2: Present Value of Cash Inflows Present Value of Cash Outflows $ $ 1,147,570.14 911,000.00 (Sum of Cash Outflows-Alternative 2) 1.26 Part C: Alternative 1 will provide the higher rate of return, but alternative 2 results in a greater net present value. Please provide additional reasons as to why either alternative should be selected. city and uses a common carrier ed approximately $ 8 million of cash way to invest these funds. o expand the fleet of city vans at a s into new markets, thereby increasing . The additional vans are expected to have an uire additional working capital of used to purchase large trucks to duce continuous improvement in operating and a $ 70,000 salvage value. In addition to $ 21,000. f Cash Outflows-Alternative 1) f Cash Outflows-Alternative 2) eater net present value. Sample Problem #2 Using net present value and internal rate of return to evaluate investment opportunities Mario Salazar, the president of Salazar Enterprises, is considering two investment opportunities. Because of limited resources, he will be only able to invest in only one of them. Project A is to purchase Equipment that will enable factory automation, the equipment is expected to have a useful life of four years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $250,000 and for Project B are $100,000. The annual expected cash inflows are $ 82,000 for Project A and $ 34,500 for Project B. Both investments are expected to provide cash flow benefits for the next four years. Salazar Enterprises cost of capital is 6 percent. Required: A. Compute the net present value of each project. Which project should be adopted based on the net present value approach? Round your computation to two decimal points. B. Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach? Round your rates to six decimal points. C. Compare the net present value approach with the internal rate of return approach. Which method is better in the given circumstances? Why? Part A Project A Cash Inflows Annual cash inflows Cash Outflows $ 82,000 Table Value Present Value 3.465106* $ 284,138.69 Cost of investment $ (250,000.00) Net Present Value Project B Cash Inflows Annual cash inflows Cash Outflows $ $ 34,138.69 Table Value Present Value 34,500 3.465106* $ 119,546.16 Cost of investment Net Present Value $ (100,000.00) $ 19,546.16 *Table 2, n=4, r=6% Since Project A results in a greater net present value than Project B, Project A should be selected based on the net present value method. Part B Project A: Present Value Table Factor X $82,000 = $250,000 Present Value Table Factor = $250,000/82,000 Present Value Table Factor 3.048780 Looking at Table 2, at row 4, we find the factor 3.037349, which is very close to the computed 3.048780, under the rate of return column marked 12%. Hence, 12% is the approximate internal rate of return. Project B: Present Value Table Factor X $34,500 = $100,000 Present Value Table Factor = $100,000/34,500 Present Value Table Factor 2.898551 Looking at Table 2, at row 4, we find the factor 2.913712, which is very close to the computed 2.898551, under the rate of return column marked 14%. Hence, 14% is the approximate internal rate of return. Since Project B has a greater internal rate of return, it should be adopted according to the internal rate of return method. Part C: Please compare the two approaches. Which method is better? Please explain your choice of method. unities. Because of se Equipment that will nd no salvage value. the current equipment. nnual expected cash ed to provide cash flow d on the net present adopted based on the ich method is better uted 3.048780, under the rate of uted 2.898551, under the rate of internal rate of return method. of method