Larrys Athletic Lounge is planning an expansion program to increase the sophistication of its exercise equipment. Larry is considering some new equipment priced at $20,000 with an estimated life of five years. Larry is not sure how many members the new equipment will attract, but he estimates his increased yearly cash flows for each of the next five years will have the following probability distribution. Larrys cost of capital is 14 percent (Probability) Cash Flow 4 4.800 6,000 7.200 a. What is the expected value of the cash flow? The value you compute will apply to each of the five years b. What is the expected net present value? c. Should Larry buy the new equipment? Solution: Larry's Athletic Lounge Expected Cash Flow $2400 2$480 4,800 1920 6.000 431 1800 7,200 720 Expected cash flow 4920 b $4, 920X 3433(PVIFA 14%, n=5)=(Appendix D) $16,890 Present value of inflows 20000 Present value of outflows S3, 110) Net present value c. Larry should not buy this equipment because the net present value is negative CopyrightC 2005 by The McGray-Hill Companies, Inc. S-492
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-492 13-12. Larry’s Athletic Lounge is planning an expansion program to increase the sophistication of its exercise equipment. Larry is considering some new equipment priced at $20,000 with an estimated life of five years. Larry is not sure how many members the new equipment will attract, but he estimates his increased yearly cash flows for each of the next five years will have the following probability distribution. Larry’s cost of capital is 14 percent. P (Probability) Cash Flow .2............ $2,400 .4............ 4,800 .3............ 6,000 .1............ 7,200 a. What is the expected value of the cash flow? The value you compute will apply to each of the five years. b. What is the expected net present value? c. Should Larry buy the new equipment? Solution: Larry’s Athletic Lounge a. Expected Cash Flow $2,400 x .2 $ 480 4,800 x .4 1,920 6,000 x .3 1,800 7,200 x .1 720 Expected cash flow $4,920 b. $4,920 x 3.433 (PVIFA @ 14%, n = 5) = (Appendix D) $16,890 Present value of inflows 20,000 Present value of outflows $(3,110) Net present value c. Larry should not buy this equipment because the net present value is negative
13-13 Silverado Mining Company is analyzing the purchase of two silver mines. Only one investment will be made. The Alaska mine will cost $2 000000 and will produce $400,000 per year in years 5 through 15 and $800,000 per year in years 16 through 25. The Montana mine will cost $2, 400,000 and will produce $300,000 per year for the next 25 years. The cost of capital is 10 percent a. Which investment should be made? (Note: In looking up present value factors for this problem, you need to work with the concept of a deferred annuity for the Alaska mine. The returns in years 5 through 15 actually represent 1 l years; the returns in years 16 through 25 represent 10 years. b. If the Alaska mine justifies an extra 5 percent premium over the normal cost of capital because of its riskiness and relative uncertainty of flows, does the investment decision change? Solution Silverado mining Company a. Calculate the net present value for each project The alaska mine Cash Present Years Flow n Factor PVIFA @ 10% value 5-15$400,000(15-4)(7606-3.170)$1,774,400 16-25$800,000(25-15)(9.077-7606)$1176800 Present value of inflows $2,951,200 Present value of outflows $2.000000 Net present valu $951,200 S-493 ght C 2005 by The McGramr-Hill Co
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-493 13-13. Silverado Mining Company is analyzing the purchase of two silver mines. Only one investment will be made. The Alaska mine will cost $2,000,000 and will produce $400,000 per year in years 5 through 15 and $800,000 per year in years 16 through 25. The Montana mine will cost $2,400,000 and will produce $300,000 per year for the next 25 years. The cost of capital is 10 percent. a. Which investment should be made? (Note: In looking up present value factors for this problem, you need to work with the concept of a deferred annuity for the Alaska mine. The returns in years 5 through 15 actually represent 11 years; the returns in years 16 through 25 represent 10 years.) b. If the Alaska mine justifies an extra 5 percent premium over the normal cost of capital because of its riskiness and relative uncertainty of flows, does the investment decision change? Solution: Silverado Mining Company a. Calculate the net present value for each project. The Alaska Mine Years Cash Flow n Factor PVIFA @ 10% Present Value 5-15 $400,000 (15 – 4) (7.606 – 3.170) $1,774,400 16-25 $800,000 (25 – 15) (9.077 – 7.606) $1,176,800 Present value of inflows $2,951,200 Present value of outflows $2,000,000 Net present value $ 951,200