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Savanna Company is considering two capital investment proposals. Relevant data on each project are as follows: Project Red Project BlueCapital investment $440,000 $640,000Annual net income $25,000 $60,000Estimated useful life 8 years 8 yearsDepreciation is computed by the straight-line method with no salvage value. Savanna requires an 8% rate of return on all new investments. The present value of 1 for 8 periods at 8% is .540 and the present value of an annuity of 1 for 8 periods is 5.747.(a) Compute the cash payback period for each project.(b) Compute the net present value for each project.(c) Compute the annual rate of return for each project.(d) Which project should Savanna select?

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Answer:

(a) Cash payback period:

     Project Red = 5.5 years

     Project blue  = 4.6 years

(b) Net present value for project Red = $19,760

     Net present value for project Blue =$164,580

(c) Annual rate of return:

Project Red =11.36%

Project Blue  =18.75%

(d) Project Blue

Explanation:

Given Data;  

Project Blue Capital investment = $640,000

Project Red Capital investment = $440,000

Project Red  Annual Net income = $ 25,000.

Project Blue Annual Net income = $ 60,000

Annual depreciation Project Red = (440000/8)

                                                       = 55,000

Annual depreciation Project Blue = (640000/8)

                                                       =  80,000

Annual cash inflow project A = $ 80,000

Annual cash inflow project B = $140,000

(a)

Cash payback period = Initial investment/cash flow per period

Project Red = 440000 /80000

                   = 5.5 years

Project blue = 640000/ 140000

                    = 4.6 years

(b)

Project Red  Present value of cash inflows = 80000 ×5.747

                                                                       = $459,760

Project Blue Present value of cash inflows  =140000×5.747

                                                                        = 804580

Net present value for project Red = $459,760 - $440,000

                                                        = $19,760

Net present value for project Blue = 804580 - $640,000  

                                                         =$164,580

(c) Annual rate of return:

Project Red   = $25,000 / ($440000)/2

                       =11.36%

Project Blue =  $60000/(640000/2)

                    =18.75%

(d) Savanna should select Project Blue because it has a higher positive NPV and a higher annual rate of return. AND Project Blue has early cash back period also

(a) The cash payback period for project red and project blue is 5.5 years and 4.6 years.

(b) The net present value for project red and project blue is $19,760 and $164,580

(c) The annual rate of return for project red and project blue is 11.36% and 18.75%.

d. The project blue should be selected.

Calculation of cash payback period, net present value, the annual rate of return:

For Project Blue

Capital investment = $640,000

Annual Net income = $ 60,000

So, Annual depreciation = (640000/8) = $80,000

Annual cash inflow = $140,000

For Project Red

Capital investment = $440,000

Annual Net income = $ 25,000

So, Annual depreciation = (440000/8) = $55,000

Annual cash inflow = $80,000

(a) The cash payback period is

= Initial investment/cash flow per period

For Project Red

= 440000 /80000

= 5.5 years

And,

Project blue

= 640000/ 140000

= 4.6 years

(b)

The net present value

For Project red

Present value of cash inflows = 80000 ×5.747

= $459,760

So,

Net present value

= $459,760 - $440,000

= $19,760

For Project Blue

Present value of cash inflows  =140000×5.747

= 804580

So,

Net present value  

= 804580 - $640,000  

=$164,580

(c) The annual rate of return is

Project Red   = $25,000 / ($440000)/2

=11.36%

Project Blue =  $60000/(640000/2)

=18.75%

(d) Savanna should select Project Blue since it contains a higher positive NPV and a greater annual rate of return also a good payback period.

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