Ursus, Inc., is considering a project that would have a ten-year life and would require a $1,000,000 investment in equipment. At the end of ten years, the project would terminate and the equipment would have no salvage value. The project would provide net operating income each year as follows (Ignore income taxes.): Sales $2,000,000 Variable expenses 1,400,000 Contribution margin 600,000 Fixed expenses: Fixed out-of-pocket cash expenses$300,000 Depreciation 100,000 400,000 Net operating income $200,000 All of the above items, except for depreciation, represent cash flows. The company's required rate of return is 12%.See separate Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using the tables
provided.Required:a. Compute the project's net present value.b. Compute the project's internal rate of return to the nearest whole percent.c. Compute the project's payback period.d. Compute the project's simple rate of return.
What will be an ideal response?
a.
Because depreciation is the only noncash item on the income statement, the annual net cash flow can be computed by adding back depreciation to net operating income.
| Net operating income | $ | 200,000 |
| Depreciation | 100,000 | |
| Annual net cash inflow | $ | 300,000 |
| Year | ||||||
| Now | 1-10 | |||||
| Initial investment | $ | (1,000,000 | ) | |||
| Annual net cash flow | $ | 300,000 | ||||
| Total cash flows (a) | $ | (1,000,000 | ) | $ | 300,000 | |
| Discount factor (12%) (b) | 1.000 | 5.650 | ||||
| Present value of cash flows (a) × (b) | $ | (1,000,000 | ) | $ | 1,695,000 | |
| Net present value | $ | 695,000 | ||||
The formula for computing the factor of the internal rate of return (IRR) is:
Factor of the IRR = Investment required ÷ Annual net cash inflow
= $1,000,000 ÷ $300,000 = 3.333
This factor is closest to the present value of an annuity over 10 years at 27%. Therefore, to the nearest whole percent, the internal rate of return is 27%.
c.
The formula for the payback period is:
Investment required ÷ Annual net cash inflow = Payback period
$1,000,000 ÷ $300,000 per year = 3.33 years
d.
The formula for the simple rate of return is:
Simple rate of return = Net operating income ÷ Initial investment
= $200,000 ÷ $1,000,000 = 20.0%
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