What you will learn to do: Use time value of money to analyze investment options
Let’s take a look at JuxtaPos again, but in this case, management is considering adding a line of puzzles that necessitates a new machine that will cost $230,000 with an estimated useful life of 6 years and a residual value of $40,000.
Estimated net cash inflows are as follows:
| Description | Amount |
|---|---|
| Year 1 | $ 60,000 |
| Year 2 | 60,000 |
| Year 3 | 55,000 |
| Year 4 | 55,000 |
| Year 5 | 50,000 |
| Year 6 | 65,000 |
| Single Line$ 345,000Double line |
You have calculated the payback at 4 years:
| Description | Amount |
|---|---|
| Cost of new machine | $ 230,000 |
| Recaptured YR 1 | $ (60,000) |
| Left to recapture | Single Line$ 170,000 |
| Recaptured YR 2 | $ (60,000) |
| Left to recapture | Single Line$ 110,000 |
| Recaptured YR 3 | $ (55,000) |
| Left to recapture | Single Line$ 55,000 |
| Recaptured YR 4 | $ (55,000) |
| Left to recapture | Single Line$ – |
And the accounting rate of return:
| Description | Amount |
|---|---|
| Total net cash inflows | $ 345,000 |
| Depreciation on machine | $ 190,000 |
| Accounting income | Single Line$ 155,000 |
| Operating life in years | 6 |
| Average annual operating income | Single Line$ 25,833 |
| Investment | $ 230,000 |
| Residual value | $ 40,000 |
| Net investment (depreciable value) | Single Line$ 190,000 |
| Divided by: | 2 |
| Average amount invested | Single Line$ 95,000 |
| Accounting rate of return | 27.19% |
So far, this project has made it through all of the internal screening processes and is now at the highest levels for approval. Upper management is now asking for a more sophisticated analysis. The CEO and CFO and the capital planning team would like to know the net present value of the project as well as the internal rate of return, along with a profitability index. They have set a hurdle rate of 15% based on the company’s WACC (weighted average cost of capital). Let’s walk through creating this analysis.
When you are done with this section, you will be able to:
- Calculate the net present value of a capital project
- Calculate the internal rate of return
- Calculate the profitability index
Learning Activities
The learning activities for this section include the following:
- Reading: Net Present Value
- Self Check: Net Present Value
- Reading: Internal Rate of Return
- Self Check: Internal Rate of Return
- Reading: Profitability Index
- Self Check: Profitability Index
