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Demonstration Problem

Chapter 16 Exercise 17
Calculate NPV Compare to IRR
Accounting
What the Numbers Mean 9e
Problem Definition
Sun Bay Manufacturing, Ltd. Is considering
the investment of $230,000 in a new
machine. The machine will generate cash
flow of $40,000 per year for each year of its
eight-year life and will have a salvage value
of $26,000 at the end of its life. The
companys cost of capital is 10%.
Problem Requirements
a. Calculate the net present value of the
proposed investment. (Ignore income
taxes.)
b. What will the internal rate of return on this
investment be relative to the cost of capital?
Explain your answer.
Problem Solution
a. Calculate the net present value of the
proposed investment. (Ignore income
taxes.)



Set up a model for analyzing the timing of
cash flows and enter all cash flows generated
by this project.
Model for analyzing project cash flows:
Problem Solution


Solution Steps:
Step 1 Setup the project
years and cash flow items.
Model for analyzing project cash flows:
Problem Solution


Solution Steps:
Step 1 Setup the project
years and cash flow items.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment


Solution Steps:
Step 1 Setup the years
and cash flow items.
Solution Steps:
Step 1 Setup the project
years and cash flow items.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment
Annual cash flow


Solution Steps:
Step 1 Setup the years
and cash flow items.
Solution Steps:
Step 1 Setup the project
years and cash flow items.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment
Annual cash flow
Salvage value

Solution Steps:
Step 1 Setup the years
and cash flow items.
Solution Steps:
Step 1 Setup the project
years and cash flow items.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment
Annual cash flow
Salvage value

Solution Steps:
Step 2 Enter all
cash flow amounts.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment $(230,000)
Annual cash flow
Salvage value

Solution Steps:
Step 2 Enter
investment amount.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment $(230,000)
Annual cash flow $40,000
Salvage value

Solution Steps:
Step 2 Enter annual
cash flow amount.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment $(230,000)
Annual cash flow $40,000
Salvage value $26,000

Solution Steps:
Step 2 Enter salvage
value amount.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment $(230,000)
Annual cash flow $40,000
Salvage value $26,000

Solution Steps:
Step 3 Calculate
the present value of
the cash flows.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment $(230,000)
Annual cash flow $40,000
Salvage value $26,000
Present Value:
$(230,000)

Solution Steps:
Step 3 Calculate the
present value of the
cash flows.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment $(230,000)
Annual cash flow $40,000
Salvage value $26,000
x 5.3349 Present Value:
$(230,000)
213,396

PV factor Table 6-5:
8 period row, 10% column
Solution Steps:
Step 3 Calculate the
present value of the
cash flows.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment $(230,000)
Annual cash flow $40,000
Salvage value $26,000
x 5.3349 x .4665 Present Value:
$(230,000)
213,396
12,129

PV factor Table 6-4:
8 period row, 10% column
Solution Steps:
Step 3 Calculate the
present value of the
cash flows.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment $(230,000)
Annual cash flow $40,000
Salvage value $26,000
x 5.3349 x .4665 Present Value:
$(230,000)
213,396
12,129

Solution Steps:
Step 4 Calculate the
net present value of the
proposed investment.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment $(230,000)
Annual cash flow $40,000
Salvage value $26,000
x 5.3349 x .4665 Present Value:
$(230,000)
213,396
12,129
$ (4,475) Net Present Value
Solution Steps:
Step 4 Calculate the
net present value of the
proposed investment.
Year: 0 1 2 3 4 5 6
Model for analyzing project cash flows:
Problem Solution
Investment $(230,000)
Annual cash flow $40,000
Salvage value $26,000
x 5.3349 x .4665 Present Value:
$(230,000)
213,396
12,129
$ (4,475)
Solution:
Since the NPV is
negative, the investment
does not earn the 10%
cost of capital.
Net Present Value
Year: 0 1 2 3 4 5 6
Problem Requirements
a. Calculate the net present value of the
proposed investment. (Ignore income
taxes.)
b. What will the internal rate of return on
this investment be relative to the cost of
capital? Explain your answer.
Problem Solution
Because the net present value is
negative, the internal rate of return on
this project will be lower than the cost
of capital of 10%.
Accounting
What the Numbers Mean 9e
David H. Marshall
Wayne W. McManus
Daniel F. Viele
You should now have a better understanding of
net present value and internal rate of return.

Remember that there is a demonstration problem for
each chapter that is here for your learning benefit.

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