Splash City is considering purchasing a water park in Atlanta, Georgia, $1,910,0

Question

Splash City is considering purchasing a water park in Atlanta, Georgia, $1,910,000. The new facility will generate annual net cash inflows of $481,000 for eight years. Engineers estimate that the new facilities will remain useful for eight years and have no residual value. The company uses straight-line depreciation, and its stockholders demand an annual return of 12% on investments of this nature.

Use: (Present Value of $1 Table), and (Present Value of Annuity $1 table)

Requirements 1. Compute the payback, the ARR, the NPV, the IRR, and the profitability index of this investment. First, determine the formula and calculate payback. (Round your answer to one decimal point, X.X)

________________/___________________= Payback (choices are: amount invested, average amount invested, expected annual net cash flow or present of net cash inflows)

_______________/______________= ______years

2. Recommend whether the company should invest in this project.

Explanation / Answer

Cost = $1,910,000 , Salvage value = NIL, Life = 8 years, Annual cash inflows = $481,000, Discount rate = 12%

1. Payback period = Initial Investment / Annual Cash inflows = 1,910,000 / 481,000 = 3.97 years

2. ARR = (Average Net Income/ Average Investment ) * 100

Average net income = Annual cash flows - Depreciation = 481,000 - 238,750 = $242,250

Average Investment = Initial Investment + Residual Value / 2 = (1,910,000 + 0) / 2 =$955,000

ARR = (242,250 / 955,000) * 100 = 25.36%

3. PV of cash inflows = 481,000 * PVAF (12% for 8 years) = 481,000 * 4.96764 = $2,389,434

Less: Cash outflow = (1,910,000)

NPV = $479,434

4. IRR factor = Investment / Annual cash inflows = 1,910,000 / 481,000 = 3.9708

Look for this value in PV annuity table for 8 years. The value is very close in the column of 19%

So IRR = 19%

5. Profitability Index = PV of cash inflows / PV of cash outflows = 2,389,434 / 1,910,000 = 1.25

Yes, the company should invest in this project as it is able to generate a positive NPV as well as a profitability index of more than 1. Hence the project is profitable.

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