Question

Linda's Luxury Travel (LLT) is considering the purchase of two Hummer limousines. Various information about the proposed investment follows:
Initial investment (2 limos) $720,000
Useful life 10 years
Salvage value $100,000
Annual net income generated 59,040
LLT's cost of capita 14%
Assume straight line depreciation method is used.
Required:
Help LLT evaluate this project by calculating each of the following:
1. Accounting rate of return.
2. Payback period.
3. Net present value.
4. Without making any calculations, determine whether the IRR is more or less than 15%.
A. Greater than 14%.
B. Less than 14%.

Answer 1

Answer:

1) Accounting rate of return is 8.2%

2) Payback period is 5.95 years

3) Net present value (NPV) is ($88,643.26)

4) Option B

Explanation:

Initial Investment = $720,000 , Useful life = 10 years , Salvage Value = $100,000

Annual Net Income generated = $59,040 , Cost of capital = 14%

Depreciation = ($720,000 - $100,000) ÷ 10 = $62,000

Annual Cash flows = $59,040 + $62,000 = $121,040

1) Accounting rate of return = (Annual Net Income ÷ Average Investment) × 100

= (59,040 ÷ 720,000) × 100

= 8.2%

2. Payback Period = Initial Investment ÷ Annual Cashflows

= 720,000 ÷ 121,040

= 5.95 years.  

3. PV of cash flows = 121,040 × PVAF(14% for 10 years)

= 121,040 × 5.2161

= $631,356.74

Less: PV of cash outflow = $720,000

Net present value (NPV) = (88,643.26)

4. If IRR = Discount rate, then NPV = 0

If IRR < Discount Rate, Then NPV is negative

If IRR > Discount Rate, Then NPV is positive

Here NPV is negative, so IRR is less than discount rate i.e.14%