Considering three capital expenditure projects. If the minimum rate of return is 10%, which projects should be undertaken?
Project Investment Annual Income Life of Project
Alpha $240,000 $13,300 6 years
Beta 270,000 19,000 9 years
Gamma 288,000 18,400 8 years
The annual income is projected to remain constant over the life of each project. There will be no salvage value at the end of the projects and the company uses straight line depreciation.
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The initial investment for the three projects, the expected annual income and the life of the project is given.
The required rate of return is 10%. The viability of the projects can be determined by looking at the net present value in each case; if the NPV is positive the project is viable. As the rate of taxation is not provided, the effect of depreciation in reducing the payable taxes cannot be determined. Depreciation should not be considered as a cash inflow and as a result does not have any relevance here.
For project Alpha:
Initial investment or cash outflow is 240000
The sum of the discounted future earnings or future cash inflow is 13300/(1.1) + 13300/(1.1)^2 + ... + 13300/(1.1)^6 = 57924.96
As the net present value for the project is a negative value it is not viable.
Similarly for Project Beta, the NPV = 270000 - (19000/1.1 + 19000/(1.1)^2 +...+19000/(1.1)^9) = -160578.5
For project Gamma, the NPV = 288000 - (18400/1.1 +18400/1.1^2+...+18400/(1.1)^8) = -189837.4
From the analysis of the cash flows for the projects none of them is viable for a 10% rate of return.
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