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INVESTMENT ANALYSIS

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.

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INVESTMENT ANALYSIS

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  1. INVESTMENT ANALYSIS PRACTICE PROBLEM

  2. 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.

  3. (a) What is the payback period? • (b) What is the simple rate of return?

  4. 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 = 0.153 = 15.3 %

  5. 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.

  6. CF0 = - 150,000 • CF1 = 18,600 • CF2 = 22,600 • CF3 = 30,600 • CF 4 = 42,600 • CF 5 = 42,600 + 85,000 = 127,600 • I/Y = 10% • NPV = $16,903 • IRR = 13.15%

  7. 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.

  8. 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

  9. CF0 = - 30,000 • CF1 = - 9,812 • CF2 = - 6,156 • CF3 = 1,470 • CF 4 = 13,065 • CF 5 = 12,625 + 85,000 = 97,625 • I/Y = 12% • NPV = $21,076 • IRR = 22.42%

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