The Summitt Petroleum Corporation will purchase an asset that qualifies for three-year MACRS depreciation. The cost is $180,000 and the asset will provide the following stream of earnings before depreciation and taxes for the next four years:

The Summitt Petroleum Corporation will purchase an asset that qualifies for three-year MACRS depreciation. The cost is $180,000 and the asset will provide the following stream of earnings before depreciation and taxes for the next four years: Use Table 12-12.

 

Year 1	$	96,000
Year 2		110,000
Year 3		48,000
Year 4		46,000

 

The firm is in a 35 percent tax bracket and has a cost of capital of 12 percent. Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods.

 

a.	Calculate the net present value. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places.)

 

Net present value

$

 

b.	Under the net present value method, should Summitt Petroleum Corporation purchase the asset?
	Yes

 
Explanation:

a.

First, determine annual depreciation.

Year	Depreciation Base		Percentage Depreciation (Table 12-12)			Annual Depreciation
1	$	180,000		.333		$	59,940
2		180,000		.445			80,100
3		180,000		.148			26,640
4		180,000		.074			13,320
						$	180,000

Then, determine the annual cash flow.

	Year 1			Year 2			Year 3			Year 4
EBDT	$	96,000		$	110,000		$	48,000		$	46,000
Depreciation		59,940			80,100			26,640			13,320
EBT	$	36,060		$	29,900		$	21,360		$	32,680
Taxes		12,621			10,465			7,476			11,438
EAT	$	23,439		$	19,435		$	13,884		$	21,242
Depreciation		59,940			80,100			26,640			13,320
Cash flow	$	83,379		$	99,535		$	40,524		$	34,562

Then, determine the net present value.

NPV	=	−$180,000 + ($83,379 / 1.12) + ($99,535 / 1.122) + ($40,524 / 1.123) + ($34,562 / 1.124)
	=	$24,603.19

b.

The asset should be purchased as the NPV is positive at the 12 percent cost of capital.

Calculator Solution:

Press the following keys: CF, 2nd, CLR WORK.

Calculator displays CF0, enter 180,000 +|−, press the Enter key.

Press down arrow, enter 83,379, and press Enter.

Press down arrow, enter 1, and press Enter.

Press down arrow, enter 99,535, and press Enter.

Press down arrow, enter 1, and press Enter.

Press down arrow, enter 40,524, and press Enter.

Press down arrow, enter 1, and press Enter.

Press down arrow, enter 34,562, and press Enter.

Press down arrow, enter 1, and press Enter.

Press NPV; calculator shows I = 0; enter 12 and press Enter.

Press down arrow; calculator shows NPV = 0.00.

Press CPT; calculator shows NPV = 24,603.19

Appendix Solution:

Year	Cash Flow (Inflows)	PVIF at 12%			Present Value
1	$ 83,379		.893		$	74,457.45
2	99,535		.797			79,329.40
3	40,524		.712			28,853.09
4	34,562		.636			21,981.43
	Present value of inflows				$	204,621.36
	Present value of outflows					180,000.00
	Net present value				$	24,621.36

X-treme Vitamin Company is considering two investments, both of which cost $11,000. The cash flows are as follows:

X-treme Vitamin Company is considering two investments, both of which cost $11,000. The cash flows are as follows:

 

Year	Project A			Project B
1	$	15,000		$	8,000
2		6,000			5,000
3		5,000			10,000

Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods.

a-1.	Calculate the payback period for Project A and Project B. (Round your answers to 2 decimal places.)

	Payback Period
Project A	year(s)
Project B	year(s)

a-2.	Which of the two projects should be chosen based on the payback method?
	Project A

b-1.	Calculate the net present value for Project A and Project B. Assume a cost of capital of 8 percent.(Do not round intermediate calculations and round your final answers to 2 decimal places.)

	Net Present Value
Project A	$
Project B	$

 

b-2.	Which of the two projects should be chosen based on the net present value method?
	Project A

 

c.	Should a firm normally have more confidence in the payback method or the net present value method?
	Net present value method

 
Explanation:

a-1.
 

Project A:

  

	Cash flows			Amount yet to be Recovered
Initial investment				$	11,000
Year 1	$	15,000			0
Year 2		6,000			0
Year 3		5,000			0

 

The initial investment is fully recovered between Year 0 and Year 1. The partial year is computed as the amount that still needs to be recovered at the end of Year 0 divided by the Year 1 cash flow, so:

 

Payback periodA	= 0 + ($11,000 / $15,000)
	= .73 year(s)

Project B:

  

	Cash flows			Amount yet to be Recovered
Initial investment				$	11,000
Year 1	$	8,000			3,000
Year 2		5,000			0
Year 3		10,000			0

The initial investment is fully recovered between Year 1 and Year 2. The partial year is computed as the amount that still needs to be recovered at the end of Year 1 divided by the Year 2 cash flow, so:

Payback periodB	= 1 + ($3,000 / $5,000)
	= 1.60 year(s)

a-2.

Under the payback method, you should select Project A because of the shorter payback period.

b-1.
 

Net present valueA	=	−$11,000 + ($15,000 / 1.08) + ($6,000 / 1.082) + ($5,000 / 1.083)
	=	$12,002.08
Net present valueB	=	−$11,000 + ($8,000 / 1.08) + ($5,000 / 1.082) + ($10,000 / 1.083)
	=	$8,632.42

b-2.

Under the net present value method, you should select Project A because of the higher net present value.

c. 

A firm should normally have more confidence in the net present value method because it considers all of a project's cash flows and also the time value of money.

 

Calculator Solution:

b-1.

Project A:

Press the following keys: CF, 2nd, CLR WORK.

Calculator displays CF0, enter 11,000 +|- key, press the Enter key.

Press down arrow, enter 15,000 and press Enter.

Press down arrow, enter 1 and press Enter.

Press down arrow, enter 6,000 and press Enter.

Press down arrow, enter 1 and press Enter.

Press down arrow, enter 5,000 and press Enter.

Press down arrow, enter 1 and press Enter.

Press NPV; calculator shows I = 0; enter 8 and press Enter.

Press down arrow; calculator shows NPV = 0.

Press CPT; calculator shows NPV = 12,002.08.

b-2.

Project B:

Press the following keys: CF, 2nd, CLR WORK.

Calculator displays CF0, enter 11,000 +|- key, press Enter key

Press down arrow, enter 8,000 and press Enter.

Press down arrow, enter 1 and press Enter.

Press down arrow, enter 5,000 and press Enter.

Press down arrow, enter 1 and press Enter.

Press down arrow, enter 10,000 and press Enter.

Press down arrow, enter 1 and press Enter.

Press NPV; calculator shows I = 0; enter 8 and press Enter.

Press down arrow; calculator shows NPV = 0.

Press CPT; calculator shows NPV = 8,632.42.

Under the net present value method, you should select Project A because of the higher net present value.

Appendix Solutions:

Project A
Year	Cash Flow				PVIF			Present Value
1		$	15,000			.926			$	13,890
2			6,000			.857				5,142
3			5,000			.794				3,970
		Present value of inflows							$	23,002
		Present value of outflows								11,000
		Net present value							$	12,002

 

Project B
Year	Cash Flow				PVIF			Present Value
1		$	8,000			.926			$	7,408
2			5,000			.857				4,285
3			10,000			.794				7,940
		Present value of inflows							$	19,633
		Present value of outflows								11,000
		Net present value							$	8,633