The building and equipment are estimated to cost $1,100,000 (ignore depreciation). The building and equipment have zero estimated residual value at the end of 10 years. Munster’s required rate of return for this project is 12 percent. Net Cash Flow related to each year of the investment is as follows:
Revenue $450,000
Less:
Material cost $ 60,000
Labor 100,000
Other 10,000 170,000
Income before taxes 280,000
Taxes 68,000
Net Annual Cash Flow $212,000
(a) Determine the net present value of the investment in the service center. Should Munster invest in the service center?
(b) Calculate the internal rate of return of the investment to the nearest ½ percent.
(c) Calculate the payback period of the investment.
How do I find letter a?
To find the net present value (NPV) of the investment, you need to calculate the present value of the cash flows associated with the project and subtract the initial cost of the investment.
Here's how you can find the net present value (NPV) of the investment:
1. Calculate the present value (PV) of each year's net annual cash flow using the required rate of return (12%) and the formula for present value: PV = CF / (1+r)^n, where CF is the net annual cash flow, r is the required rate of return, and n is the number of years.
For example, using year 1 net annual cash flow of $212,000:
PV1 = 212,000 / (1+0.12)^1 = 189,285.71
Repeat this calculation for each year's net annual cash flow to get the present value for each year.
2. Calculate the present value of the initial cost of the investment. In this case, the building and equipment cost $1,100,000. Since this cost occurs at year 0, its present value is simply the same as the initial cost: PV0 = 1,100,000.
3. Sum up all the present values of net annual cash flows and subtract the present value of the initial cost to get the net present value:
NPV = PV0 + PV1 + PV2 + ... + PVn - Present value of the initial cost
In this case, since the investment is for 10 years, you would need to calculate the present value for each year's net annual cash flow (PV1, PV2, ..., PV10) and sum them up. Then subtract the present value of the initial cost (PV0) to calculate the net present value.
4. If the net present value (NPV) is positive, it indicates that the investment is expected to generate a positive return on investment. If the NPV is negative, it indicates that the investment is expected to result in a negative return.
Therefore, if the net present value (NPV) is greater than zero (NPV > 0), Munster should invest in the service center. If the net present value is less than zero (NPV < 0), Munster should not invest.
By following these steps, you can calculate the net present value and determine whether Munster should invest in the service center or not.