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 = = 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.

YearBefore Tax CF DeprTaxable Inc Inc Tax After Tax CF 120,00013,0007,0001,40018, ,00013,00012,0002,40022, ,00013,00022,0004,40030, ,00013,00037,0007,40042, ,00013,00037,0007,40042,600

CF0 = - 150,000 CF1 = 18,600 CF2 = 22,600 CF3 = 30,600 CF 4 = 42,600 CF 5 = 42, ,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

YearBefore Tax CF DeprInterest Expense Taxable Inc Inc Tax Loan Payment After Tax CF 120,00013,00010,200-3, ,452-9, ,00013,0008,4793, ,452-6, ,00013,0006,61115,3893,07830,4521, ,00013,0004,58432,4166,48330,45213, ,00013,0002,38634,6146,92330,45212,625

CF0 = - 30,000 CF1 = - 9,812 CF2 = - 6,156 CF3 = 1,470 CF 4 = 13,065 CF 5 = 12, ,000 = 97,625 I/Y = 12% NPV = $21,076 IRR = 22.42%