Hearne Company has a number of potential capital investments. Because these proj
ID: 2454813 • Letter: H
Question
Hearne Company has a number of potential capital investments. Because these projects vary in nature, initial investment, and time horizon, management is finding it difficult to compare them. Assume straight line depreciation method is used.
This project would require an initial investment of $4,900,000. It would generate $874,000 in additional net cash flow each year. The new machinery has a useful life of eight years and a salvage value of $1,012,000.
The patent would cost $3,435,000, which would be fully amortized over five years. Production of this product would generate $446,550 additional annual net income for Hearne.
Hearne could purchase 25 new delivery trucks at a cost of $120,000 each. The fleet would have a useful life of 10 years, and each truck would have a salvage value of $5,100. Purchasing the fleet would allow Hearne to expand its customer territory resulting in $360,000 of additional net income per year.
1. Using a discount rate of 10 percent, calculate the net present value of each project
2. Determine the profitability index of each project and prioritize the projects for Hearne
Hearne Company has a number of potential capital investments. Because these projects vary in nature, initial investment, and time horizon, management is finding it difficult to compare them. Assume straight line depreciation method is used.
Explanation / Answer
(1) NPV
NPV is the sum of discounted cash inflows & outflows.
(a)
(b)
Annual amortization = $3,435,000 / 5 = $687,000
Net Annual cash flow = Annual income - Amortization = $(446,550 - 687,000) = - $240,450
(c)
Total initial cost = 25 x $120,000 = $3,000,000
Total salvage value = 25 x $5,100 = $127,500
(2)
Profitability Index = PV of cash inflows / Absolute value of Initial cost
Since Project A has PI > 1, this should be undertaken and has top priority. Project B has a positive PI < 1 and should not be undertaken. Project C having negative PI is to be rejected at once.
Project 1 Year Cost ($) Annual Cash Flow ($) Discount Factor @10% Discounted Cash Flow ($) 0 -49,00,000 1.0000 -49,00,000 1 8,74,000 0.9091 7,94,545 2 8,74,000 0.8264 7,22,314 3 8,74,000 0.7513 6,56,649 4 8,74,000 0.6830 5,96,954 5 8,74,000 0.6209 5,42,685 6 8,74,000 0.5645 4,93,350 7 8,74,000 0.5132 4,48,500 8 8,74,000 0.4665 4,07,727 8 10,12,000 0.4665 4,72,105 PV of Cash Inflows = 51,34,831 NPV = 2,34,831Related Questions
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