investment analysis practice problem. a fertilizer dealer is considering the purchase of a new piece...
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INVESTMENT ANALYSIS
PRACTICE PROBLEM
• A fertilizer dealer is considering the purchase of a new piece of equipment the will allow him to vary the application rates of fertilizer across a field.
• This new machine will cost him $150,000. He expects to increase his cash flows by $20,000 in year one, $25,000 in year two, and $35,000 in year 3 and $50,000 for the next 2 years.
• The estimated value of the machine at the end of 5 years is $85,000. Depreciation is calculated using the straight line method using a salvage value of $85,000 and a life of 5 years.
• (a) What is the payback period?
• (b) What is the simple rate of return?
• To get the annual cash flows average the annual cash flow estimates: (20,000+25,000+35,000+50,000+50,000)/5 = $36,000
• Depreciation is calculated as: (150,000-85,000)/5 = 65,000/5 = $13,000
• Payback Period = $150,000/$36,000 = 4.17 years
• Simple Rate of Return = ($36,000-13,000)/($150,000) = $23,000/$150,000 = 0.153 = 15.3 %
• Evaluate the purchase of the new fertilizer application machine using after tax cash flows with a marginal tax rate of 20 % using
• (a) Net Present Value (using an 8% cost of capital) over a 5 year time horizon
• (b) Internal Rate of Return.
Year Before Tax CF
Depr Taxable Inc
Inc Tax
After Tax CF
1 20,000 13,000 7,000 1,400 18,600
2 25,000 13,000 12,000 2,400 22,600
3 35,000 13,000 22,000 4,400 30,600
4 50,000 13,000 37,000 7,400 42,600
5 50,000 13,000 37,000 7,400 42,600
• CF0 = - 150,000• CF1 = 18,600• CF2 = 22,600• CF3 = 30,600• CF 4 = 42,600• CF 5 = 42,600 + 85,000 = 127,600
• I/Y = 10%
• NPV = $16,903
• IRR = 13.15%
• The fertilizer dealer can finance the new machine with the equipment dealer. Terms of the loan would be 20% down payment financed over 5 years at 8.5% using a level payment amortization schedule. Evaluate the investment using
• (a) Net Present Value (using an 12% cost of capital) over a 5-year time horizon
• (b) Internal Rate of Return.
• Amount of down payment = $150,000 * 0.20 = $30,000
• Amount financed = $150,000 - $30,000 = $120,000
• Amount of annual payments:
• PV = 120,000• P/Y = 1• I/Y = 8.5 %• N = 5
• PMT = - 30,452
Year Before Tax CF
Depr Interest Expense
Taxable Inc
Inc Tax
Loan Payment
After Tax CF
1 20,000 13,000 10,200 -3,200 -640 30,452 -9,812
2 25,000 13,000 8,479 3,521 704 30,452 -6,156
3 35,000 13,000 6,611 15,389 3,078 30,452 1,470
4 50,000 13,000 4,584 32,416 6,483 30,452 13,065
5 50,000 13,000 2,386 34,614 6,923 30,452 12,625
• CF0 = - 30,000• CF1 = - 9,812• CF2 = - 6,156• CF3 = 1,470• CF 4 = 13,065• CF 5 = 12,625 + 85,000 = 97,625
• I/Y = 12%
• NPV = $21,076
• IRR = 22.42%