Thunder Corporation, an amusement park

Question:

Thunder Corporation, an amusement park, is considering a capital investment in a new exhibit. The exhibit would cost $136,000 and have an estimated useful life of 5 years. It will be sold for $60,000 at that time. (Amusement parks need to rotate exhibits to keep people interested.) It is expected to increase net annual cash flows by $25,000. The company’s borrowing rate is 8%. Its cost of capital is 10%. Click here to view PV table.

Calculate the net present value of this project to the company and determine whether the project is acceptable. (If the net present value is negative, use either a negative sign preceding the number eg -45 or parentheses eg (45). For calculation purposes, use 5 decimal places as displayed in the factor table provided. Round present value answer to 0 decimal places, e.g. 125.)

Answer:

General Guidance

Capital budgeting:

Capital budgeting refers to a process in which the future investments and the expenses are evaluated in order to determine which investment will be best for the company. This process helps to know which investment project will provide higher returns to the company.

The process of capital budgeting includes the decisions regarding the investment and the capital expenditure is planned and evaluated. It helps to know which investment will be more profitable to the company when compared with the other investment options.

Net Present Value is a technique which helps to take decision whether a project should be accepted or not. The Net present value refers to the value which is computed by deducting the initial investment or present value of outflows from the present value of inflows. It considers time value of money in evaluating capital investments.

Net Present Value is calculated as:

Here:

CF – Future Cash Flows

k- The firm’s required rate of return or cost of capital

IO – Initial Investment

n- Expected life of the project

Step: 1

Calculate the net present value of project.

Following schedule shows the net present value of the project:

The net present value of Project is ($3,975).

Following schedule shows the calculation:

Explanation:The net present value refers to the amount which is obtained when the present value of cash flows is deducted from the present value of cash inflows. The cash inflows for Project are $25,000 in each year for five years and $60,000 in year 5 and the cash outflows is $136,000. So, the net present value of Project is ($3,975).

[Hint for the next step]

Use the information to determine whether project should be accepted.

Step: 2

The decision whether to accept or reject the project is taken on the basis of following:

. The project which results in positive net present value should be accepted by the company because the returns that will be provided by the project will be higher than the returns provided at the required rate of return or cost of capital of the project.

. The project which results in zero net present value should be accepted by the company because the returns that will be provided by the project will be equal to the returns provided at the required rate of return or cost of capital of the project.

. The project which results in negative net present value should not be accepted by the company because the returns that will be provided by the project will be less than the returns provided at the required rate of return or cost of capital of the project.

Explanation:The project which results in negative net present value should not be accepted by the company because the returns that will be provided by the project will be lower than the returns provided at the required rate of return or cost of capital of the project. The net present value of the project is ($3,975), which is negative, so the project should not be accepted by the company.

So final answer is:

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