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Demonstration Problem Chapter 16 – Exercise 17 Calculate NPV – Compare to IRR Accounting What the Numbers Mean 9e

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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%.

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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.

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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.

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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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Model for analyzing project cash flows: Problem Solution Investment $(230,000) Annual cash flow $40,000 Salvage value $26,000 x 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

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Model for analyzing project cash flows: Problem Solution Investment $(230,000) Annual cash flow $40,000 Salvage value $26,000 x 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

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Model for analyzing project cash flows: Problem Solution Investment $(230,000) Annual cash flow $40,000 Salvage value $26,000 x 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

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Model for analyzing project cash flows: Problem Solution Investment $(230,000) Annual cash flow $40,000 Salvage value $26,000 x 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

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Model for analyzing project cash flows: Problem Solution Investment $(230,000) Annual cash flow $40,000 Salvage value $26,000 x 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

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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.

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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%.

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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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