Question

Merrill Corp. has the following information available about a potential capital investment:

Initial investment................. $1,100,000
Annual net income.............. $110,000
Expected life........................ 8 years
Salvage value....................... $120,000
Merrill's cost of capital........ 7%

Assume straight line depreciation method is used.

Required:
1. Calculate the project’s net present value.
2. Without making any calculations, determine whether the internal rate of return (IRR) is more or less than 7 percent.
3. Calculate the net present value using a 13 percent discount rate.
4. Without making any calculations, determine whether the internal rate of return (IRR) is more or less than 13 percent.

Answer 1

Answer:

1. Year Cashflow DF@7%       PV

            $                     $

0        (1,1000,000) 1    (1,100,000)

1-8              110,000 5.9713        656,843

8                 120,000       0.5820       69,840

                                           NPV        (373,317)

2. The internal rate of return is less than 7% since the net present value is negative.

3. Year Cashflow DF@13%       PV

            $                     $

0        (1,1000,000) 1    (1,100,000)

1-8              110,000 4.7988       527,868

8                 120,000       0.3762        45,144

                                             NPV      (526,988)

4. The internal rate of return is less than 13% since the net present value is negative.

Explanation:

Net present value  is the difference between present value of inflow and present value of outflow. In this case, we will discount the cashflow for year 1  to year 8 using annuity factor at the appropriate cost of capital. The cashflow for year 8 is the salvage value. This cashflow will be discounted at the applicable discount factor for year 8. Present value is obtained by multiplying the cashflows by the discount factors. Finally, we will determine the NPV by deducting the present value of initial outlay from the present value of cash inflows.