Chapter 4

(Questions)

4-1. In your own words, what is the meaning of

a. present worth? (4.3)

Answers:
Present worth refers to the value of a future sum of money or cash flow in today's currency. It is a financial concept
that involves discounting future cash flows to account for the time value of money, inflation, and other factors. In
essence, present worth determines how much money would need to be invested today in order to generate a
specific amount of cash in the future. It is used in financial analysis and decision-making to compare cash flows that
occur at different points in time.

b. capital recovery cost? (4.5)

Answers:
Capital recovery cost refers to the amount of money or investment required to recover the initial cost of an asset or
investment over a specific period of time. It is also known as the recovery of investment, cost recovery, or payback.
Capital recovery cost is calculated based on the total cost of the investment, the period of time over which the
investment will generate cash flows, and the expected rate of return or interest rate. The purpose of calculating the
capital recovery cost is to determine how quickly an investment will generate positive cash flows and recover the
initial investment cost. It is a critical factor in evaluating the profitability of an investment and making sound
financial decisions.

c. minimum attractive rate of return? (4.2)

Answers:
Minimum attractive rate of return (MARR) is the minimum percentage or rate of return that an investor or
organization requires to justify an investment or project. This rate is also known as the hurdle rate or the required
rate of return. MARR is the minimum acceptable rate of return that a project must generate to compensate the
investor for the risks and costs associated with that investment. The MARR is typically calculated based on a
variety of factors, such as the investor's opportunity costs, the level of risk associated with the investment, and the
desired return on investment. In other words, MARR is the lowest rate of return that makes the investment
worthwhile and attractive to the investor. It is an important criterion used in capital budgeting analysis to evaluate
and select investment projects. If an investment project cannot generate returns higher than the MARR, it is
typically not considered worthwhile or feasible.

4-2. You are faced with a decision on an in- vestment proposal. Specifically, the estimated additional income from
the investment is $180,000 per year, the initial investment costs are $640,000; and the estimated annual costs are
$44,000, which begin decreasing by $4,000 per year starting at the end of the third year. Assume an 8-year analysis
period, no salvage value, and MARR = 15%. (4.3, 4.6)

a. What is the PW of this proposal?

Answers:

To calculate the present worth of this investment proposal, we need to determine the net cash flow for each year
and then use the present worth formula:
PW = Σ (Net Cash Flow / (1 + MARR)^n)
Where:
PW = Present Worth
Σ = Summation (i.e., adding up all the terms over the specified range of n values)
Net Cash Flow = the net cash flow in year n
MARR = minimum attractive rate of return
n = the year (1-8)
Year 0:
Initial Investment: -640,000
Year 1:
Net Cash Flow = +180,000 - 44,000
Net Cash Flow = +136,000
Year 2:
Net Cash Flow = +180,000 - 44,000
Net Cash Flow = +136,000
Year 3:
Net Cash Flow = +180,000 - 44,000
Net Cash Flow = +136,000
Year 4:
Net Cash Flow = +180,000 - (44,000 - 4,000)
Net Cash Flow = +136,000
Year 5:
Net Cash Flow = +180,000 - (44,000 - 8,000)
Net Cash Flow = +144,000
Year 6:
Net Cash Flow = +180,000 - (44,000 - 12,000)
Net Cash Flow = +148,000
Year 7:
Net Cash Flow = +180,000 - (44,000 - 16,000)
Net Cash Flow = +152,000
Year 8:
Net Cash Flow = +180,000 - (44,000 - 20,000)
Net Cash Flow = +156,000
Now, we can use the present worth formula to find the present worth of the investment proposal:
PW = (-640,000 / (1+0.15)^0) + (136,000 / (1+0.15)^1) + (136,000 / (1+0.15)^2) + (136,000 / (1+0.15)^3) +
(136,000 / (1+0.15)^4) + (144,000 / (1+0.15)^5) + (148,000 / (1+0.15)^6) + (152,000 / (1+0.15)^7) + (156,000 /
(1+0.15)^8)
PW = -$640,000 + $118,853.92 + $102,864.00 + $89,285.20 + $77,433.91 + $70,747.61 + $64,462.92 + $58,537.82
+ $52,936.89
PW = $75,189.47
Therefore, the present worth of this proposal is $75,189.47. This means that the investment proposal is not
attractive because the present worth is less than the initial investment of $640,000.

b. What is the IRR of this proposal?

Answer:
To calculate the internal rate of return (IRR) of this investment proposal, we need to find the rate of return that
makes the net present value (NPV) equal to zero. We can use the trial-and-error method or a financial calculator to
find the IRR.

Using the trial-and-error method, we can calculate the NPV of the investment proposal at different discount rates
until we find the rate that makes the NPV equal to zero. We can start with a discount rate of 10% and increase it
gradually until we find the IRR.
At a discount rate of 10%, the NPV is:

NPV = -640,000 + 136,000/ (1+0.10) + 136,000/ (1+0.10) ^2 + 136,000/ (1+0.10) ^3 + 136,000/ (1+0.10) ^4 +
144,000/ (1+0.10) ^5 + 148,000/ (1+0.10) ^6 + 152,000/ (1+0.10) ^7 + 156,000/ (1+0.10) ^8
NPV = $72,286.92

At a discount rate of 20%, the NPV is:

NPV = -640,000 + 136,000/(1+0.20) + 136,000/(1+0.20)^2 + 136,000/(1+0.20)^3 + 136,000/(1+0.20)^4 +
144,000/(1+0.20)^5 + 148,000/(1+0.20)^6 + 152,000/(1+0.20)^7 + 156,000/(1+0.20)^8
NPV = -$50,781.99
The IRR is between 15% and 20% because the NPV changes sign between these discount rates.
We can use interpolation to estimate the IRR more precisely. The difference between the two NPVs is $123,068.91.
The difference between the two discount rates is 10% (20% - 10%). The amount by which we need to increase the
discount rate to make the NPV zero is:
$75,189.47 / $123,068.91 x 10% = 6.12%

Therefore, the IRR is approximately:

IRR = 15% + 6.12% = 21.12%

The IRR of this investment proposal is approximately 21.12%. This means that the investment proposal is
attractive because the IRR is higher than the MARR of 15%.

4-3. a. Evaluate machine XYZ on the basis of the PW method when the MARR is 12%. Pertinent cost data are as
follows: (4.3)

MACHINE XYZ
First Cost $13,000
Useful Life 15 Years
Salvage Value $3,000
Annual Operating Cost 100
Overhaul – end of fifth year 200
Overhaul – end of tenth year 550

Answer:
To evaluate machine XYZ using the PW method, we need to calculate the present worth of all cash flows associated
with the machine over its 15-year useful life.
First, let's calculate the annual net cash flow for each year:
- Year 0: -$13,000 (initial cost)
- Year 1-15: $3,100 - $100 = $3,000 (annual revenue from salvage value minus annual operating cost)
- Year 5 and 10: -$200 - $550 = -$750 (cost of overhauls)
Next, we can use the PW formula to find the present worth of all cash flows:
PW = Σ (Net Cash Flow / (1 + MARR)^n)
Where:
PW = Present Worth
Σ = Summation (i.e., adding up all the terms over the specified range of n values)
Net Cash Flow = the net cash flow in year n
MARR = minimum attractive rate of return
n = the year (0-15)
Using a financial calculator or spreadsheet software, we can find the present worth as follows:
PW = (-$13,000) + ($3,000 / 1.12) + ($3,000 / 1.12^2) + ... + ($3,000 / 1.12^15) - ($750 / 1.12^5) - ($750 /
1.12^10)
PW = -$13,000 + $734.38 + $653.62 + ... + $161.54 - $385.48 - $229.50
PW = -$11,094.41
Therefore, using the PW method and a MARR of 12%, the present worth of machine XYZ is -$11,094.41. This means
that the machine does not meet the investment criteria and is not economically feasible.

b. Determine the capital recovery cost of machine XYZ by all three formulas presented in the text. (4.4)
Answer:

Now, let's calculate the capital recovery cost of machine XYZ using the three formulas presented in the text:
1. Arithmetic Gradient Present Worth Factor (AGPWF) Formula:
AGPWF = [r(1 + r)^n] / [(1 + r)^n - 1]
AGPWF = [0.12(1 + 0.12)^15] / [(1 + 0.12)^15 - 1]
AGPWF = 0.1609
CRC = (CF × AGPWF) + PF
where:
CF = Annuity Cash Flow
PF = Present Worth of the Final Value
CF = $3,000 - ($13,000 - $3,000) (0.12 / 0.88) (1 - 0.88^15) / (1 - 0.88)
CF = $813.02
PF = -$3,000 / 1.12^15
PF = -$494.98
CRC = ($813.02 × 0.1609) + (-$494.98)
CRC = -$370.16
Therefore, using the AGPWF formula, the capital recovery cost of machine XYZ is -$370.16.
2. Capital Recovery Factor (CRF) Formula:
CRF = [r(1 + r)^n] / [(1 + r)^n - 1]
CRF = [0.12(1 + 0.12)^15] / [(1 + 0.12)^15 - 1]
CRF = 0.0797
CRC = (Investment × CRF)
CRC = ($13,000 - $3,000) × 0.0797
CRC = $636.91 (Note: This produces a positive value because we are calculating cost and not benefit).

Therefore, using the CRF formula, the capital recovery cost of machine XYZ is $636.91.
3. Present Worth Equivalent (PWE) Formula:
PWE = 1 / [(1 + r)^n]
PWE = 1 / (1 + 0.12)^15
PWE = 0.0992
CRC = (Investment + Annual Costs × PWE)
CRC = ($13,000 - $3,000) + ($100 + $200 + $550) × 0.0992
CRC = $690.68 (Note: This produces a positive value because we are calculating cost and not benefit).
Therefore, using the PWE formula, the capital recovery cost of machine XYZ is $690.68.

4-4.
a. Determine the PW and AW of the following proposal when the MARR is 15%. (4.3, 4.4)

Proposal A
First Cost $10,000
Expected Life 5 Years
Salvage Value -$1,000
Annual Receipts 8,000
Annual Expenses 4,000

“A negative salvage value means that there is a net cost to dispose of an asset.

Answer:
To calculate the present worth (PW) and annual worth (AW) of proposal A, we need to determine the net cash flow
for each year of the expected life of the project. The net cash flow is the difference between the annual receipts and
annual expenses.
Year 0: -$10,000 (first cost)
Year 1-5: $8,000 - $4,000 = $4,000 (annual receipts minus annual expenses)
Year 5: -$1,000 (salvage value)
Using the PW formula, we can calculate the present worth of the net cash flows:
PW = Σ((Net Cash Flow / (1 + MARR)^n)
where:
MARR = minimum attractive rate of return
n = the year (0-5)
PW = -$10,000 + ($4,000 / (1 + 0.15)^1) + ($4,000 / (1 + 0.15)^2) + ($4,000 / (1 + 0.15)^3) + ($4,000 / (1 +
0.15)^4) + ($4,000 + (-$1,000)) / (1 + 0.15)^5
PW = -$10,000 + $3,478.26 + $3,027.88 + $2,640.67 + $2,310.34 + $1,933.67
PW = $3,390.41
Using the AW formula, we can calculate the annual worth of the net cash flows:
AW = (PW x MARR) / (1 - (1 + MARR)^-n)
AW = ($3,390.41 x 0.15) / (1 - (1 + 0.15)^-5)
AW = $1,009.21
Therefore, the present worth of proposal A is $3,390.41, and the annual worth of proposal A is $1,009.21.

b. Determine the IRR for proposal A, Is it Acceptable? (4.6)

Answer:
To calculate the internal rate of return (IRR) of proposal A, we need to find the rate of return that makes the net
present value (NPV) equal to zero. We can use the trial-and-error method or a financial calculator to find the IRR.
At a discount rate of 14%, the NPV is:
NPV = -$10,000 + ($4,000 / 1.14^1) + ($4,000 / 1.14^2) + ($4,000 / 1.14^3) + ($4,000 / 1.14^4) + ($4,000 -
$1,000) / 1.14^5
NPV = $862.19
At a discount rate of 16%, the NPV is:
NPV = -$10,000 + ($4,000 / 1.16^1) + ($4,000 / 1.16^2) + ($4,000 / 1.16^3) + ($4,000 / 1.16^4) + ($4,000 -
$1,000) / 1.16^5
NPV = $728.11
The IRR is between 14% and 16% because the NPV changes sign between these discount rates.
Using interpolation, we can estimate the IRR as follows:
IRR = 14% + ($862.19 / ($862.19 - $728.11)) × (16% - 14%)
IRR = 14% + 1.02%
IRR = 15.02%
The IRR of proposal A is 15.02%. This is acceptable because it is greater than the MARR of 15%.

c. What is the B/C ratio for this proposal? (4.7)

Answer:
The benefit-cost (B/C) ratio of proposal A is calculated as follows:
B/C ratio = Present Value of Benefits / Present Value of Costs
The present value of benefits is the present worth of the annual receipts over the useful life of the project:
Present Value of Benefits = ($8,000 x ((1 - (1 + 0.15)^-5) / 0.15)) = $26,145.62
The present value of costs is the present worth of the first cost and the salvage value:
Present Value of Costs = -$10,000 + (-$1,000 / 1.15^5) = -$11,772.44
B/C ratio = $26,145.62 / -$11,772.44
B/C ratio = -2.22
The B/C ratio of proposal A is negative, indicating that the project is not economically justified.
4-5. A company is considering constructing a plant to manufacture a proposed new product. The land costs
$300,000, the building costs $600,000, the equipment costs $250,000, and $100,000 working capital is required. It
is expected that the product will result in sales of $750,000 per year for 10 years, at which time the land can be sold
for $400,000, the building for $350,000, and the equipment for $50,000 and all of the working capital recovered.
The annual out-of-pocket expenses for labor, mate- rials, and all other items are estimated to total $475,000. If the
company requires an MARR of 25% on projects of comparable risk, determine if it should invest in the new product
line. Use the PW method. (4.3)

Answer:

To determine whether the company should invest in the new product line, we need to calculate the present worth
(PW) of all cash inflows and outflows using the PW method with a minimum attractive rate of return (MARR) of
25%.

The relevant cash inflows and outflows are:

- Initial investment:
-$1,250,000 ($300,000 for land, $600,000 for building, $250,000 for equipment, and $100,000 for working capital)
- Annual sales revenue: $750,000
- Annual out-of-pocket expenses: -$475,000
- Salvage value: $800,000 ($400,000 for land, $350,000 for building, and $50,000 for equipment)

Using the PW formula, we can calculate the present worth of the net cash flows:

PW = [(Annual Sales Revenue

- Annual Out-of-Pocket Expenses) / (1+MARR) ^n] - (Initial Investment - Salvage Value) / (1+MARR) ^n

where:
MARR = minimum attractive rate of return
n = the year (0-10)
Year 0: -$1,250,000 Year 1-10: ($750,000 - $475,000) / (1 + 0.25) ^n = $188,587.90 / year Year 10: $800,000 PW =
-1,250,000 + (188,587.90 / 0.25) x (1 - (1 + 0.25) ^-10) - 800,000 / (1 + 0.25) ^10

PW = -$1,420,335.86 The present worth of the net cash flows is negative, indicating that the project is not
economically

4-6. Uncle Wilbur's trout ranch is now for sale for $40,000. Annual property taxes, maintenance, supplies,
and so on are estimated to continue to be $3,000 per year. Revenues from the ranch are expected to be
$10,000 next year and then. to decline by $500 per year thereafter through the tenth year. If you bought
the ranch, you would plan to keep it for only 5 years and at that time to sell it for the value of the land,
which is $15,000. If your desired annual rate of return is 12%, should you become a trout rancher? Use
the PW method. (4.3)

Answer:
To determine whether it is economically feasible to buy Uncle Wilbur's trout ranch, we need to calculate
the present worth (PW) of the net cash flows using the PW method with a minimum attractive rate of
return (MARR) of 12%.

The relevant cash inflows and outflows are:

- Initial purchase price:
-$40,000
- Annual expenses: -$3,000
- Annual revenue for the first 5 years: $10,000, $9,500, $9,000, $8,500, $8,000
- Salvage value: $15,000

Using the PW formula, we can calculate the present worth of the net cash flows:

PW = [(Annual Revenue - Annual Expenses) / (1+MARR)^n] - (Initial Purchase Price - Salvage Value) /
(1+MARR)^n

where: MARR = minimum attractive rate of return

n = the year (0-5)

Year 0: -$40,000
Year 1: ($10,000 - $3,000) / (1+0.12)^1 = $6,696.43
Year 2: ($9,500 - $3,000) / (1+0.12)^2 = $5,865.51
Year 3: ($9,000 - $3,000) / (1+0.12)^3 = $5,078.40
Year 4: ($8,500 - $3,000) / (1+0.12)^4 = $4,332.20
Year 5: ($8,000 - $3,000) / (1+0.12)^5 = $3,623.31 Salvage value: $15,000

PW = -40,000 + ($6,696.43 / 1.12^1) + ($5,865.51 / 1.12^2) + ($5,078.40 / 1.12^3) + ($4,332.20 /

1.12^4) + ($3,623.31 / 1.12^5) + (15,000 / 1.12^5)

PW = -$4,778.34

The present worth of the net cash flows is negative, indicating that the project is not economically
feasible. Therefore, based on the PW method with a MARR of 12%, it is not recommended to become a
trout rancher by buying Uncle Wilbur's trout ranch for $40,000.

4-7. A friend of yours just purchased a $10,000 bond that was discounted to sell for $7,500. It is a 6%
bond with interest payable annually that matures in 7 years. In exactly 3 years, your friend plans to sell
the bond at a price that gives the buyer a 12% interest rate compounded annually. For how much will
your friend sell the bond? (4.3)

Answer:
To find out how much your friend can sell the bond for in 3 years, we need to first calculate the total
amount of money your friend will receive from the bond at maturity (i.e., 7 years from now) considering
the purchase price of $7,500 and the 6% annual interest rate. Let's call this amount FV (future value).

We can use the future value formula to calculate this:

FV = PV(1 + r)^n

where:
PV = present value ($7,500)
r = annual interest rate (6% or 0.06)
n = number of years until maturity (7)
FV = $7,500(1 + 0.06)^7
FV = $11,684.57

Now, we need to find out how much your friend can sell the bond for in 3 years to give the buyer a 12%
interest rate compounded annually. Let's call this amount P (selling price). We can use the present value
formula to calculate this:

P = FV / (1 + r)^n

where:
r = annual interest rate (12% or 0.12)
n = number of years until maturity (4, since 3 years have already passed)
P = $11,684.57 / (1 + 0.12)^4

P = $7,507.04

Therefore, your friend can sell the bond for approximately $7,507.04 in 3 years to give the buyer a 12%
interest rate compounded annually.

4-8. How much can be paid a $5,000, 14% bond, with interest paid semiannually, if the bond matures 12
years hence? Assume that the purchaser will be satisfied with 9% nominal interest compounded
semiannually. (4.3).

Answer:

To determine the present worth of the bond, we need to calculate the semiannual coupon payments and
the maturity value of the bond, and then use the present value formula to find the amount that satisfies
the given conditions.

The semiannual coupon payment can be calculated as:

Coupon Payment = Face Value x Semiannual Interest Rate Coupon Payment

= $5,000 x (14%/2)
= $350

The number of payment periods will be 2 x 12 = 24

,since there are 24 semiannual periods in 12 years.

The maturity value of the bond is just the face value of the bond, which is $5,000.

Now, we can use the present value formula to determine how much can be paid for the bond:

Present Value = Coupon Payment x [1 - (1 + r)^-n] / r + Face Value / (1 + r)^n

where:
r = semiannual interest rate = 9%/2 = 4.5%
n = total number of semiannual periods = 24
Present Value = $350 x [1 - (1 + 0.045)^-24] / 0.045 + $5,000 / (1 + 0.045)^24
Present Value = $3,007.09
4-9. A 20-year bond with a face value of $5,000 is offered for sale at $3,800. The rate of interest on the
bond is 7%, paid semiannually. This bond is now 10 years old (i.e., the owner has received 20 semiannual
interest payments). If the bond is purchased for $3,800, what effective rate of interest would be realized
on this investment opportunity? (4.3)

Answer:
First, we need to calculate the remaining interest payments that the buyer would receive:

Number of remaining semiannual interest payments

= (20 years - 10 years) x 2
= 20 semiannual payments - 20 received payments
= 20

Next, we can use the present value formula to calculate the present value of these remaining interest
payments:

PV = C * [1 - (1 + r/2)^-n] / (r/2)

Where PV is the present value of the remaining interest payments, C is the semiannual coupon payment
(which is equal to 7% of the face value divided by 2), r is the semiannual interest rate (which is equal to
7% divided by 2), and n is the number of semiannual payments remaining.

Plugging in the numbers, we get:

PV = (0.07 * $5,000 / 2) * [1 - (1 + 0.07/2)^-20] / (0.07/2) = $1,631.25

Therefore, the total investment would be $3,800 + $1,631.25 = $5,431.25.

To calculate the effective rate of interest, we can use the following formula:

Effective Rate = (Total Future Value / Total Present Value)^(1/n) - 1

Where Total Future Value is the sum of the face value ($5,000) and all remaining interest payments, Total
Present Value is the purchase price ($3,800) plus the present value of the remaining interest