Exercise 172 Exercise 172 Savanna Company is considering two capital investment
ID: 2806203 • Letter: E
Question
Exercise 172
Exercise 172
Savanna Company is considering two capital investment proposals. Relevant data on each project are as follows:Project Red Project Blue Capital investment $440,000 640,000 Annual net income 25,000 60,000 Estimated useful life 8 years 8 years
Depreciation is computed by the straight-line method with no salvage value. Savanna requires an 8% rate of return on all new investments. The present value of 1 for 8 periods at 8% is .540 and the present value of an annuity of 1 for 8 periods is 5.747.
Explanation / Answer
Depreciation p.a= Original Cost- Salvage Value/ Life of Asset
Project Red:
=$440,000-$0/8
=$440,000/8
=$55,000
Project Blue:
=$640,000-$0/8
=$640,000/8
=$80,000
Computation of Cash flow= Annual net income + Depreciation
Project Red:
=$25,000+$55,000
=$80,000
Project Blue:
=$60,000+$80,000
=$140,000
Cash back period = Initial Investment/ Cash flow
Project Red:
= $440,000/$80,000
=5.5 years
Project Blue:
= $640,000/$80,000
=4.57 years
Project Red
Project Blue
Cash payback period
5.5years
4.57 years
Project Red:
Year
Cashflow
PV Factor @ 8%
PV
0
$ (4,40,000)
1
$ (4,40,000.00)
1
$ 80,000
0.9259
$ 74,074.07
2
$ 80,000
0.8573
$ 68,587.11
3
$ 80,000
0.7938
$ 63,506.58
4
$ 80,000
0.7350
$ 58,802.39
5
$ 80,000
0.6806
$ 54,446.66
6
$ 80,000
0.6302
$ 50,413.57
7
$ 80,000
0.5835
$ 46,679.23
8
$ 80,000
0.5403
$ 43,221.51
NPV
$ 19,731.12
Project Blue:
Year
Cashflow
PV Factor @ 8%
PV
0
$ (6,40,000)
1
$ (6,40,000.00)
1
$ 1,40,000
0.9259
$ 1,29,629.63
2
$ 1,40,000
0.8573
$ 1,20,027.43
3
$ 1,40,000
0.7938
$ 1,11,136.51
4
$ 1,40,000
0.7350
$ 1,02,904.18
5
$ 1,40,000
0.6806
$ 95,281.65
6
$ 1,40,000
0.6302
$ 88,223.75
7
$ 1,40,000
0.5835
$ 81,688.66
8
$ 1,40,000
0.5403
$ 75,637.64
NPV
$ 1,64,529.45
Annual rate of return = Annual Net income / Avg investment
Project Red:
=$25,000/($440,000/2)
=$25,000/$220,000
=11.36%
Project Blue:
=$60,000/($640,000/2)
=$60,000/$320,000
=25%
Project Red
Project Blue
Annual rate of return
11.36%
25%
Project Blue should be selected as Cash payback period less , and NPV and Annual rate of return is high
Project Red
Project Blue
Cash payback period
5.5years
4.57 years
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