CH,8 1. A project has an initial cost of $40,000 and a four-year life. The compa

Question

CH,8

1.

A project has an initial cost of $40,000 and a four-year life. The company uses straight-line depreciation to a book value of zero over the life of the project. The projected net income from the project is $1,300, $1,500, $1,700, and $4,500 a year for the next four years, respectively. What is the average accounting return?

5.63 percent

56.25 percent

8.89 percent

22.50 percent

11.25 percent

2.

What is the internal rate of return on an investment with the following cash flows?

  

29.92 percent

9.97 percent

37.13 percent

5.44 percent

12.38 percent

3.

What is the profitability index for an investment with the following cash flows given a 6 percent required return?

  

0.87

0.77

1.06

1.15

1.29

4.

8.46 percent; 7.29 percent; 8.59 percent

8.46 percent; 7.38 percent; 8.61 percent

8.54 percent; 7.29 percent; 8.61 percent

8.54 percent; 7.38 percent; 8.59 percent

8.54 percent; 8.23 percent; 8.61 percent

5. Drill Question

You’re trying to determine whether or not to expand your business by building a new manufacturing plant. The plant has an installation cost of $17.4 million, which will be depreciated straight-line to zero over its four-year life.

If the plant has projected net income of $1,755,000, $2,115,000, $1,974,000, and $1,296,000 over these four years, what is the project’s average accounting return (AAR)?

6.

What is the IRR of the above set of cash flows?

Year Cash Flow 0 –$118,000 1 40,900 2 42,100 3 48,450

Explanation / Answer

1. Investment and income in each year are entered in a table as follows

Average accounting return = average of last column = 22.50%. So option d

2. After entering cash flows in an excel, IRR can be calculated using the formula

IRR(A1:A4) = 5.44%. So option d

3. Profitability Index = PV of future cash flows / Initial Investment

Enter cash flows in an excel and find the PV using the formula as

=NPV(A1:A3) = 24056.54

So Profitability Index = 24056.54 / 21000 = 1.15. So option d.

4. Enter cash flows in an excel sheet, MIRR with combination method can be calculated using the formula

=MIRR(A1:A6,10%,10%) = 8.59%

Reinvestment approach:
[t=5] cashflow = 8400x(1+10%)^4 + 19900x(1+10%)^3 + 43800x(1+10%)^2 +
+ 13500x(1+10%)^1 -4200/(1+10%) = 102815.1582

0 = -68000 + 102815.1582/(1+MIRR)^5
Solving equation we get: MIRR 8.54%

So option d.

Income Cost Return 1300 10000 13.00% 1500 10000 15.00% 1700 10000 17.00% 4500 10000 45.00%

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