Drake Corporation is reviewing an investment proposal. The initial cost and esti

Question

Drake Corporation is reviewing an investment proposal. The initial cost and estimates of the book value of the investment at the end of each year, the net cash flows for each year, and the net income for each year are presented in the schedule below. All cash flows are assumed to take place at the end of the year. The salvage value of the investment at the end of each year is equal to its book value. There would be no salvage value at the end of the investment’s life. Investment Proposal Year Initial Cost and Book Value Annual Cash Flows Annual Net Income 0 $105,900 1 69,200 $44,600 $7,900 2 43,000 39,700 13,500 3 21,800 34,400 13,200 4 6,400 30,200 14,800 5 0 24,600 18,200 Drake Corporation uses an 11% target rate of return for new investment proposals.

Explanation / Answer

The question can be solved by calculating the NPV of the Investment:

Cash flows during the life of project:

Year 0: -105900

Year 1: 44600

Year 2: 39700

Year 3: 34400

Year 4: 30200

Year 5: 24600

NPV = - 105900 + 44600/1.11 + 39700/1.11^2 + 34400/1.11^3 + 30200/1.11^4 + 24600/1.11^5

= 26147.15

Since NPV is greater than zero, the Investment should be taken up.

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