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Linda's Luxury Travel (LLT) is considering the purchase of two Hummer limousines. Various information about the proposed investment

follows:
Initial investment (2 limos)
Useful life
$ 720,000
10 years
$ 100,000
$ 59,040
14
Salvage value
Annual net income generated
LLT's cost of capital
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. (Future Value of $1,Present Value of $1, Future Value Annuity of $1, Present Value Annuity of $1.)
Note: Use appropriate factor(s) from the tables provided.
4. Without making any calculations, determine whether the IRR is more or less than 14%.

User Anjuman
by
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1 Answer

4 votes

Accounting Rate of Return (ARR):

ARR is calculated by dividing the average annual net income generated by the initial investment and expressing it as a percentage.

Step 1: Calculate the average annual net income generated.

Average annual net income = (Annual net income generated year 1 + Annual net income generated year 14) / 2

Average annual net income = ($59,040 + $59,040) / 2 = $59,040

Step 2: Calculate the ARR.

ARR = (Average annual net income / Initial investment) x 100

ARR = ($59,040 / $720,000) x 100 ≈ 8.18%

Payback Period:

The payback period is the time it takes for the initial investment to be recovered from the net cash flows.

Step 1: Calculate the annual net cash flows.

Annual net cash flows = Annual net income generated - Annual depreciation expense

Annual net cash flows = $59,040 - ($720,000 - $100,000) / 10

Annual net cash flows = $59,040 - $62,000 = -$2,960

Step 2: Calculate the payback period.

Payback period = Initial investment / Annual net cash flows

Payback period = $720,000 / $2,960 ≈ 243.24 years

Net Present Value (NPV):

NPV is calculated by discounting the net cash flows over the useful life of the investment at the cost of capital and subtracting the initial investment.

Step 1: Calculate the discount factor using the cost of capital (14%).

Discount factor (n=10, i=14%) = 1 / (1 + 0.14)^10 ≈ 0.20648

Step 2: Calculate the present value of each year's net cash flow and sum them up.

NPV = (Net cash flow year 1 x Discount factor year 1) + (Net cash flow year 2 x Discount factor year 2) + ... + (Net cash flow year 10 x Discount factor year 10) - Initial investment

NPV ≈ ($59,040 x 0.20648) + ($59,040 x 0.20648) + ... + ($59,040 x 0.20648) - $720,000

NPV ≈ $12,196.19

Without making any calculations, determine whether the IRR is more or less than 14%.

The Internal Rate of Return (IRR) is the discount rate at which the NPV becomes zero. Since the cost of capital provided (14%) is already greater than the ARR (8.18%), we can infer that the IRR is less than 14%.

User NMGod
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7.6k points