Consider the following investment opportunity. Initial cost: $850,000 Annual rev

Question

Consider the following investment opportunity.

Initial cost: $850,000

Annual revenues: $500,000

Annual operating costs, exclusive of depreciation: $200,000

Expected life: 20 years

Salvage value after taxes: $40,000

Annual depreciation for tax purposes: $25,000

Tax rate: 34%

Assume the annual figures are unchanged for the expected life of the investment.

1. What is the rate of return on this investment?

2. Assuming the investor wants to earn at least 12 percent, is this investment an attractive one?

Please provide calculation details

Explanation / Answer

Part 1)

To calculate IRR, we need to determine the annual after-tax cash flow as follows:

The IRR can be calculated with the use of IRR function/formula of EXCEL/Financial Calculator. The basic function/formula for IRR is given below:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3 + Cash Flow Year 4/(1+IRR)^4 + Cash Flow Year 5/(1+IRR)^5 + Cash Flow Year 6/(1+IRR)^6 + Cash Flow Year 7/(1+IRR)^7.........................................+ Cash Flow Year 15/(1+IRR)^15 + Cash Flow Year 16/(1+IRR)^16 + Cash Flow Year 17/(1+IRR)^17 + Cash Flow Year 18/(1+IRR)^18 + Cash Flow Year 19/(1+IRR)^19 + Cash Flow Year 20/(1+IRR)^20

The IRR has been calculated with the use of EXCEL in the following formula:

IRR = 23.98% (answer for Part 1)

_________

Part 2)

For a project to be acceptable, we need to calculate the NPV at 12%. The formula for calculating NPV is given below:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Required Return)^1 + Cash Flow Year 2/(1+Required Return)^2 + Cash Flow Year 3/(1+Required Return)^3 + Cash Flow Year 4/(1+Required Return)^4 + Cash Flow Year 5/(1+Required Return)^5 + Cash Flow Year 6/(1+Required Return)^6 + Cash Flow Year 7/(1+Required Return)^7.........................................+ Cash Flow Year 15/(1+Required Return)^15 + Cash Flow Year 16/(1+Required Return)^16 + Cash Flow Year 17/(1+Required Return)^17 + Cash Flow Year 18/(1+Required Return)^18 + Cash Flow Year 19/(1+Required Return)^19 + Cash Flow Year 20/(1+Required Return)^20

Using the values of after-tax cash flow, we get,

NPV = -850,000 + 206,500/(1+12%)^1 + 206,500/(1+12%)^2 + 206,500/(1+12%)^3 + 206,500/(1+12%)^4 + 206,500/(1+12%)^5 + 206,500/(1+12%)^6 + 206,500/(1+12%)^7 + 206,500/(1+12%)^8 + 206,500/(1+12%)^9 + 206,500/(1+12%)^10 + 206,500/(1+12%)^11 + 206,500/(1+12%)^12 + 206,500/(1+12%)^13 + 206,500/(1+12%)^14 + 206,500/(1+12%)^15 + 206,500/(1+12%)^16 + 206,500/(1+12%)^17 + 206,500/(1+12%)^18 + 206,500/(1+12%)^19 + 246,500/(1+12%)^20 = $696,586.78

As the NPV is positive, the investment is attractive and can be accepted at 12% rate of return.

Annual Revenue 500,000 Less Annual Operating Costs 200,000 Depreciation 25,000 Earnings Before Tax 275,000 Less Tax (275,000*34%) 93,500 Earnings After Tax 181,500 Add Depreciation 25,000 After-Tax Cash Flow $206,500

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