Balloons By Sunset (BBS) is considering the purchase of two new hot air balloons

Question

Balloons By Sunset (BBS) is considering the purchase of two new hot air balloons so that it can expand its desert sunset tours. Various information about the proposed investment follows Initial investment (for two hot air balloons) 415,000 Useful life Salvage value Annual net income generated BBS's cost of capital 8 years $ 47,000 38,180 7% Assume straight line depreciation method is used Required: Help BBS evaluate this project by calculating each of the following . Accounting rate of return. (Round your answer to 1 decimal place.) Accounting Rate of Return 2. Payback period. (Round your answer to 2 decimal places.) Payback Period 4.93 Years

Explanation / Answer

BASIC DETAILS:

Initial Investment(cost of machine) = $ 415,000

Useful life = 8 years

Salvage value= $ 47,000

Annual net income = $ 38,180

Cost of capital = 7%

Depreciation = (Cost of machine- Salvage value)/ Useful life

                                = ($ 415,000- $ 47,000)/ 8 years

                                =$ 46,000

1. ACCOUNTING RATE OF RETURN

Accounting rate of return = Average Accounting Profit/ Average Investment

                                                = $ 38,180/ $ 415,000

                                                = 9.2%

2. PAYBACK PERIOD

Payback Period = Initial Investment / Annual net Cash Inflow

Annual net Cash Inflow= Annual net income+ Depreciation

                                                = $ 38,180+ $ 46,000 = $ 84,180

                                Therefore, Payback Period = $ 415,000/ $ 84,180

                                                                                = 4.93 years

3. NET PRESENT VALUE @7%

Cost of capital = 7%

NET PRESENT VALUE = Present Value of Cash Inflow- Present Value of Cash Outflow

Annual Cash Inflow = Annual net income+ Depreciation

= $ 38,180+ $ 46,000 = $ 84,180

Net Present Value = Annual Cash Inflow (PVIFA 7%,8 )+ Salvage Value(PVIF 7%,8) –

Initial Investment

=( 84,180* 5.3893) +(47000*0.6227) – 415,000

=453,671+ 29,267- 415,000

                                =$ 67,938

4. NET PRESENT VALUE @10%

Cost of capital = 10%

NET PRESENT VALUE = Present Value of Cash Inflow- Present Value of Cash Outflow

Annual Cash Inflow = Annual net income+ Depreciation

= $ 38,180+ $ 46,000 = $ 84,180

Net Present Value = Annual Cash Inflow (PVIFA 10%,8 )+ Salvage Value(PVIF 10%,8) –

Initial Investment

= (84,180*4.8684) +(47000*0.5132) – 415,000

= 409,822+ 24,120- 415,000

= $ 18,942

Note : PVIF= Present Value Interest Factor

PVIFA = Present Value Interest Factor Annuity (Cumulative present value over the life of the project)

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