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Evaluation of Capital Projects
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MBA-FPX5014 Instructor 5/6/23
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Evaluation of Capital Projects
Executive Summary
Under President Maria Gomez's leadership, ABC Healthcare Corporation operates a diverse portfolio of medical facilities encompassing ambulatory surgical centers, hospitals, urgent care centers, and outpatient clinics. Presently, the corporation is engaged in the evaluation
of three separate capital projects aimed at bolstering shareholder value. Through the strategic application of capital budgeting tools, a comprehensive financial assessment is underway to discern the optimal project for shareholders. Key metrics such as investment costs, net present value, internal rate of return, payback period, and profitability index are scrutinized to identify the most advantageous undertaking. Upon analysis, it is determined that investing in Project C is the most lucrative approach for maximizing shareholder value.
3
Company Background
ABC Healthcare Corporation operates various healthcare facilities, including ambulatory surgical centers, hospitals, urgent care centers, and outpatient clinics. The company is considering three distinct investment opportunities: acquiring new major equipment, expanding into three additional states, and launching a significant marketing and advertising campaign. The corporation must identify which projects will benefit its shareholders most. Given that each project has unique costs and durations, various budgeting tools will be utilized to evaluate their profitability comparatively.
Capital budgeting entails the development of a financial strategy for long-term initiatives or business ventures, such as acquiring new properties or equipment, which will be funded by external revenue sources such as other departments (Ross et al., 2022). This process aids companies in assessing the risks and expected returns associated with a project. Furthermore, capital budgeting is an ongoing process that involves regular reassessment to accommodate changes in cash outflows, prevent project delays, and manage additional expenses (Booth et al., 2020). In scenarios where multiple investment options exist, leadership must carefully compare the risks and returns of each alternative to determine their profitability before deciding on which project to pursue.
Capital Budgeting
Capital budgeting is critical for companies aiming to select projects delivering optimal shareholder value. This involves thoroughly analyzing and evaluating potential investment opportunities to discern which projects will yield the highest return on investment and best serve the organization's shareholders (Ross et al., 2022). Companies can make informed decisions
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about allocating their financial resources by considering upfront costs, potential returns, risks, and expected cash flows over time.
Various metrics, including Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period, and Profitability Index (PI), are employed in capital budgeting to compare the expected returns of different projects. These metrics enable companies to identify projects offering the highest value for shareholders while mitigating risks. Choosing the wrong project can have significant financial implications and hinder a company's ability to generate profits and sustain long-term growth, underscoring the importance of capital budgeting in informed investment decision-making (Mayo, 2018). Therefore, it is essential that companies thoroughly assess all possible metrics before making the final decision on which project to invest in. Capital budgeting is crucial for companies when trying to make an investment decision. Companies may utilize multiple capital budgeting techniques to comprehensively understand a project's financial impact (Booth et al., 2020). For instance, ABC Healthcare Corporation is evaluating the profitability of three projects by calculating NPV, IRR, Payback Period, and PI. While these tools provide valuable insights into a project's potential returns, it is essential to acknowledge their limitations, such as heavy reliance on projected future cash flows and failure to account for certain factors like the time value of money.
Project A: Major Equipment Choices
ABC Healthcare is contemplating the acquisition of new major equipment, anticipating a reduction in annual sales costs by 5% over eight years. The project, estimated at $10 million, will
undergo depreciation utilizing the Modified Accelerated Cost Recovery System (MACRS) 7-
year schedule, which facilitates the recovery of equipment costs through annual deductions. Over
the equipment's lifespan, depreciation accelerates initially before tapering off in subsequent
5
years. At the end of the eighth year, the equipment can be sold for salvage at $500,000. With an 8% required rate of return and projected annual sales of $20 million throughout the project, ABC
Healthcare anticipates reducing its cost of sales from 60% to 55%, resulting in a significant financial impact. Considering a marginal corporate tax rate of 25%, the project promises substantial benefits.
Analysis reveals a positive Net Present Value (NPV) of $44,262,269, affirming the project's profitability. Despite an impressive Internal Rate of Return (IRR) of 79.79%, indicating solid returns compared to alternative projects, the extended 8-year duration suggests a steadier profit trajectory. The Payback Period for the initial equipment investment spans just over 15 months, signaling rapid repayment within 1.36 years. Furthermore, a Profitability Index (PI) of 5.43 underscores the investment's strength, with a value exceeding one indicating robust potential returns
.
Project B: 3 State Expansion
6
ABC Healthcare's second potential project entails an expansion into three additional states, anticipating a 10% annual increase in sales revenues and cost of sales over five years. Initial costs for this endeavor are estimated at $7 million, with an additional $1 million investment in net working capital, to be recuperated by the project's fifth year. Reflecting its high-risk nature, the project's required rate of return stands at 12%, aligning with a marginal corporate tax rate of 25%. Notably, the company achieved $20 million in annual sales in 2022.
The analysis reveals a positive Net Present Value (NPV) of $22,259,712 for Project B, although nearly 50% lower than that of Project A, it remains a judicious investment choice. Project B boasts an Internal Rate of Return (IRR) of 91.48%, surpassing Project A's, albeit influenced by its shorter duration. With a swift payback period of 1.14 years, equivalent to just over 13 and a half months, Project B outpaces Project A by three months in initial investment recovery. Furthermore, sporting a Profitability Index (PI) of 3.78, Project B emerges as a robust investment prospect, with its PI exceeding the one threshold.
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Project C: Marketing/Advertising The third potential project under consideration involves implementing a new major marketing and advertising campaign, incurring an annual cost of $2 million over six years. Unlike the preceding projects, this initiative spreads its expenses evenly across its duration rather
than requiring a substantial upfront investment. Projections anticipate a 15% annual increase in both sales revenues and cost of sales, surpassing the expected growth rate for Project B by 5%. With a moderate level of risk, the project necessitates a required rate of return of 10%, aligning with the company's marginal corporate tax rate of 25%. Notably, annual sales for 2022 stood at $20 million.
Analysis reveals a positive Net Present Value (NPV) of $33,470,904 for the new major marketing and advertising campaign, positioning it between the NPVs of Projects A and B and affirming its profitability. Despite a slightly lower Internal Rate of Return (IRR) of 90.36% compared to Project B, it surpasses Project A's by 11%, reflecting the project's shorter duration and potential for more rapid profit generation.
The projected payback period for this initiative is 1.23 years, falling between the payback
periods of Projects A and B. Additionally, boasting a Profitability Index (PI) of 4.84, higher than Project B but lower than Project A, the project emerges as a favorable investment opportunity
8
with a PI exceeding 4.84.
Recommendation
As highlighted earlier, profitable projects are characterized by a positive Net Present Value (NPV) and a Profitability Index (PI) exceeding one. Selecting a single project becomes imperative for companies like ABC Healthcare with limited liquid assets. Therefore, besides profitability metrics, factors such as upfront cash investment and payback period demand
9
consideration. Additionally, the Internal Rate of Return (IRR) calculation holds significance as it
gauges a project's expected profitability (Mayo, 2018). While a high-profit venture may warrant the associated risks and initial investment, compared to a lower-cost, safer alternative, a comprehensive assessment of all factors is essential before reaching a final decision (Mayo, 2018). The table below compares capital budgeting metrics, initial investment, and project duration for Projects A, B, and C.
Upon comparing the three projects, it is apparent that all are financially viable, boasting positive NPVs and profitability indexes, with anticipated profitability within two years. Each project's IRR further confirms its profitability. Project A stands out with the highest NPV and profitability index, suggesting the most substantial return on investment. Conversely, Project B exhibits the highest IRR and the shortest payback period, making it an attractive option for those seeking a quicker ROI. Project C's metrics fall between A and B, representing a moderate-risk investment with a reasonable return.
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Regarding initial investment, Project B requires the lowest upfront cost at $7,000,000, followed by Project A at $10,000,000. However, both necessitate this investment as a lump sum upfront. In contrast, Project C entails the highest total investment, spread evenly across its six-
year term, costing $2,000,000 annually. All projects are expected to benefit ABC Healthcare's shareholders financially, with Project A and B reducing production costs by 5% annually, resulting in total savings of $8,000,000 over eight years, and Project B is forecasted to increase sales by 10% annually, amounting to a total increase of $10,000,000 over five years. Project C, a marketing campaign, is projected to boost sales by 15% annually, resulting in a total increase of $18,000,000 over six years.
Considering the analysis, Project C is the most advantageous option for ABC Healthcare's shareholders. The project exhibits positive values across all four capital budgeting metrics, including NPV, IRR, Payback Period, and Profitability Index. With a projected payback period of 1.23 years and profitability within 15 months, Project C offers promising returns. While its IRR is marginally lower than Project B, its shorter six years and spread-out investment of $12,000,000 make it an appealing choice. Moreover, its forecasted sales increase of 15% annually, totaling $18,000,000, positions ABC Healthcare for swift reinvestment in subsequent projects.
Conclusion Capital budgeting is essential in helping companies assess projects before deciding which
provides the best returns and profitability. Capital budgeting techniques such as IRR, NPV, PI, and PBP are critical for a firm to apply in evaluating its investments. In most cases, NPV is the primary tool as it factors in the time value of money. Its cash flows are also discounted at the future present value, hence providing the company with an opportunity to have a clear
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perspective of the project’s future cash flows in the present (Booth et al., 2020). Other techniques
such as PBP, PI, and IRR can also be considered and, at times, be higher for a particular project. Despite this, the project exhibiting the utmost value will be chosen, provided the variations in its value from the other techniques remain rational.
12
References
Booth, L., Cleary, W. S., & Rakita, I. (2020).
Introduction to corporate finance
. John Wiley & Sons. https://books.google.co.ke/books?
hl=en&lr=&id=EXLLDwAAQBAJ&oi=fnd&pg=PA1&dq=introduction+to+finance+&o
ts=iLxpkCLOcl&sig=9u9zgIzQXgVyTyWGpgCuXjBKyY0&redir_esc=y#v=onepage&q
=introduction%20to%20finance&f=false
Mayo, H. B. (2018).
Basic finance: an introduction to financial institutions, investments, and management
. Cengage Learning. https://books.google.co.ke/books?
hl=en&lr=&id=h9VUEAAAQBAJ&oi=fnd&pg=PP1&dq=introduction+to+finance+&ot
s=XLkhfzUzts&sig=LqBzf_AqjIH2k2ss-Gg-
7QnWN_M&redir_esc=y#v=onepage&q=introduction%20to%20finance&f=false
Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2022). Fundamentals of corporate finance.
https://thuvienso.hoasen.edu.vn/bitstream/handle/123456789/12640/Contents.pdf?
sequence=1
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$50,400
$157,000
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$251,000
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50,400
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212,000
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50,400
157,000
40,000
149,000
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50,400
157,000
18,000
102,000
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$785,000
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0.943
0.909
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0.890
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0.792
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0.636
0.572
0.482
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0.747
0.621
0.567
0.497
0.402
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0.705
0.564
0.507
0.432
0.335
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0.665
0.513
0.452
0.376
0.279
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Design of Strategic Business Unit MetroBank is a fast-growing bank that serves theregion around Jacksonville, Florida. The bank provides commercial and individual banking services, including investment and mortgage banking services. The firm’s strategy is to continueto grow by acquiring smaller banks in the area to broaden the base and variety of services it canoffer. The bank now has 87 strategic business units, which represent different areas of servicein different locations. To support its growth, MetroBank has invested several million dollarsin upgrading its information services function. The number of networked computers and ofsupport personnel has more than doubled in the last 4 years and now accounts for 13% of totaloperating expenses. Two years ago, MetroBank decided to charge information services to theSBUs based on the head count (number of employees) in each SBU. Recently, some of thelarger SBUs have complained that this method overcharges them and that some of the…
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The capital investment committee of Arches Landscaping Company is considering two capital investments. The estimated operating income and net cash flows from each investment are as follows:
Front-End Loader
Greenhouse
Year
OperatingIncome
Net CashFlow
OperatingIncome
Net CashFlow
1
$44,000
$142,000
$92,000
$227,000
2
44,000
142,000
70,000
192,000
3
44,000
142,000
35,000
135,000
4
44,000
142,000
15,000
92,000
5
44,000
142,000
8,000
64,000
Total
$220,000
$710,000
$220,000
$710,000
Each project requires an investment of $400,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 15% for purposes of the net present value analysis.
Present Value of $1 at Compound Interest
Year
6%
10%
12%
15%
20%
1
0.943
0.909
0.893
0.870
0.833
2
0.890
0.826
0.797
0.756
0.694
3
0.840
0.751
0.712
0.658
0.579
4
0.792
0.683
0.636
0.572
0.482
5…
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9. The capital investment committee of Ellis Transport and Storage Inc. is considering two investment projects. The estimated income from operations and net cash flows from each investment are as follows:
Warehouse
Tracking Technology
Year
Income fromOperations
Net CashFlow
Income fromOperations
Net CashFlow
1
$42,000
$131,000
$88,000
$210,000
2
42,000
131,000
67,000
177,000
3
42,000
131,000
34,000
124,000
4
42,000
131,000
15,000
85,000
5
42,000
131,000
6,000
59,000
Total
$210,000
$655,000
$210,000
$655,000
Each project requires an investment of $420,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 15% for purposes of the net present value analysis.
Present Value of $1 at Compound Interest
Year
6%
10%
12%
15%
20%
1
0.943
0.909
0.893
0.870
0.833
2
0.890
0.826
0.797
0.756
0.694
3
0.840
0.751
0.712
0.658
0.579
4
0.792
0.683…
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Compound Interest, Balance Sheet, Profits, and Capitalization Table
3. "The MacArthur Fellowship is a $625,000, no-strings-attached award to extraordinarily talented and creative individuals as an investment in their potential. There are three criteria for selection of Fellows: (1) Exceptional creativity; (2) Promise for important future advances based on a track record of significant accomplishments; and (3) Potential for the Fellowship to facilitate subsequent creative work. Each fellowship comes with a stipend of $625,000 to the recipient, paid out in equal quarterly installments over five years (therefore, $31,250 per quarter)."
One of the recipients in 2019 was "Mary Halvorson, a guitarist, ensemble leader, and composer who is pushing against established musical categories with a singular sound on her instrument and an aesthetic that evolves with each new album and configuration of bandmates. She melds her jazz roots with elements of experimental rock, folk, and other musical…
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The capital investment committee of Arches Landscaping Company is considering two capital investments. The estimated operating income and net cash flows from each investment are as follows:
Front-End Loader
Greenhouse
Year
OperatingIncome
Net CashFlow
OperatingIncome
Net CashFlow
1
$54,000
$173,000
$113,000
$277,000
2
54,000
173,000
86,000
234,000
3
54,000
173,000
43,000
164,000
4
54,000
173,000
19,000
112,000
5
54,000
173,000
9,000
78,000
Total
$270,000
$865,000
$270,000
$865,000
Each project requires an investment of $540,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 15% for purposes of the net present value analysis.
Present Value of $1 at Compound Interest
Year
6%
10%
12%
15%
20%
1
0.943
0.909
0.893
0.870
0.833
2
0.890
0.826
0.797
0.756
0.694
3
0.840
0.751
0.712
0.658
0.579
4
0.792
0.683
0.636
0.572
0.482
5…
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CASE 4
HMD Corporation operates a high end manufacturing facility. The capital intensive
nature of the corporation's operations makes internal control over the acquisition and the
use of fixed assets important management objectives.
At the beginning of every financial year, HMD prepares a fixed asset budget that would
indicate the planning on their capital expenditure. To prepare this, managers from each
department would request capital expenditure from the senior management. This requires
them to complete a fixed asset requisition form, which must be approved by the senior
management team. HMD has established PPE (property, plant and equipment) guidance
and policies that will determine whether the fixed asset requisition is to be considered as
capital expenditure or revenue expenditure.
The management committee will meet each month to review the budget reports. Among
other things, the committee will also compare actual outcome incurred by the managers
to their forecasted figures; and…
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Net Present Value Method, Present Value Index, and Analysis
First United Bank Inc. is evaluating three capital investment projects using the net present value method. Relevant data related to the projects are summarized as follows:
BranchOfficeExpansion
ComputerSystemUpgrade
ATMKioskExpansion
Amount to be invested
$863,421
$519,486
$311,214
Annual net cash flows:
Year 1
358,000
243,000
165,000
Year 2
333,000
219,000
114,000
Year 3
304,000
194,000
83,000
Present Value of $1 at Compound Interest
Year
6%
10%
12%
15%
20%
1
0.943
0.909
0.893
0.870
0.833
2
0.890
0.826
0.797
0.756
0.694
3
0.840
0.751
0.712
0.658
0.579
4
0.792
0.683
0.636
0.572
0.482
5
0.747
0.621
0.567
0.497
0.402
6
0.705
0.564
0.507
0.432
0.335
7
0.665
0.513
0.452
0.376
0.279
8
0.627
0.467
0.404
0.327
0.233
9
0.592
0.424
0.361
0.284
0.194
10
0.558
0.386
0.322
0.247
0.162
Required:
1. Assuming that the desired rate of return is 6%,…
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The capital investment committee of Arches Landscaping Company is considering two capital investments. The estimated operating income and net cash flows from each investment are as follows:
Front-End Loader
Greenhouse
Operating
Net Cash
Operating
Net Cash
Year
Income
Flow
Income
Flow
1
$55,800
$172,000
$117,000
$275,000
55,800
172,000
89,000
232,000
3
55,800
172,000
45,000
163,000
4
55,800
172,000
20,000
112,000
55,800
172,000
8,000
78,000
Total
$279,000
$860,000
$279,000
$860,000
Each project requires an investment of $620,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 12% for purposes of the net present value analysis.
Present Value of $1 at Compound Interest
Year
6%
10%
12%
15%
20%
1
0.943
0.909
0.893
0.870
0.833
2
0.890
0.826
0.797
0.756
0.694
0.840
0.751
0.712
0.658
0.579
4
0.792
0.683
0.636
0.572
0.482
5
0.747
0.621
0.567
0.497
0.402
0.705
0.564
0.507
0.432
0.335
7
0.665
0.513
0.452
0.376
0.279
8
0.627
0.467…
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Related Questions
- Case Problem 1. Investment StrategyJ. D. Williams, Inc. is an investment advisory firm that manages more than $120 million in funds for its numerous clients. The company uses an asset allocation model that recommends the portion of each client’s portfolio to be invested in a growth stock fund, an income fund, and a money market fund. To maintain diversity in each client’s portfolio, the firm places limits on the percentage of each portfolio that may be invested in each of the three funds. General guidelines indicate that the amount invested in the growth fund must be between 20% and 40% of the total portfolio value. Similar percentages for the other two funds stipulate that between 20% and 50% of the total portfolio value must be in the income fund and that at least 30% of the total portfolio value must be in the money market fund. In addition, the company attempts to assess the risk tolerance of each client and adjust the portfolio to meet the needs of the individual investor. For…arrow_forwardFirst United Bank Inc. is evaluating three capital investment projects using the net present value method. Relevant data related to the projects are summarized as follows: BranchOfficeExpansion ComputerSystemUpgrade ATMKioskExpansion Amount to be invested $686,053 $516,654 $295,458 Annual net cash flows: Year 1 411,000 288,000 177,000 Year 2 382,000 259,000 122,000 Year 3 349,000 230,000 89,000 Present Value of $1 at Compound Interest Year 6% 10% 12% 15% 20% 1 0.943 0.909 0.893 0.870 0.833 2 0.890 0.826 0.797 0.756 0.694 3 0.840 0.751 0.712 0.658 0.579 4 0.792 0.683 0.636 0.572 0.482 5 0.747 0.621 0.567 0.497 0.402 6 0.705 0.564 0.507 0.432 0.335 7 0.665 0.513 0.452 0.376 0.279 8 0.627 0.467 0.404 0.327 0.233 9 0.592 0.424 0.361 0.284 0.194 10 0.558 0.386 0.322 0.247 0.162 Required: 1. Assuming that the desired rate of return is 20%, prepare a net present value analysis for each project. Use the…arrow_forward2. How should a company prioritize all of its capital project opportunities? In responding invoke the various methodologies learned this week and how to use them for ranking projects. At least 400 wordsarrow_forward
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- The capital investment committee of Iguana Inc. is considering two capital investments. The estimated operating income and net cash flows from each investment are as follows: Year Robotic AssemblerOperating Income Robotic AssemblerNet Cash Flow WarehouseOperating Income WarehouseNet Cash Flow 1 $55,000 $171,000 $116,000 $274,000 2 55,000 171,000 88,000 231,000 3 55,000 171,000 44,000 162,000 4 55,000 171,000 19,000 111,000 5 55,000 171,000 8,000 77,000 Total $275,000 $855,000 $275,000 $855,000 Each project requires an investment of $500,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 10% for purposes of the net present value analysis. Year 6% 10% 12% 15% 20% 1 0.943 0.909 0.893 0.870 0.833 2 0.890 0.826 0.797 0.756 0.694 3 0.840 0.751 0.712 0.658 0.579 4 0.792 0.683 0.636 0.572 0.482 5 0.747 0.621 0.567 0.497 0.402 6 0.705 0.564 0.507 0.432 0.335 7 0.665 0.513 0.452 0.376 0.279…arrow_forwardThe capital investment committee of Arches Landscaping Company is considering two capital investments. The estimated income from operations and net cash flows from each investment are as follows: Front-End Loader Greenhouse Year Income fromOperations Net CashFlow Income fromOperations Net CashFlow 1 $46,800 $144,000 $98,000 $230,000 2 46,800 144,000 75,000 194,000 3 46,800 144,000 37,000 137,000 4 46,800 144,000 16,000 94,000 5 46,800 144,000 8,000 65,000 Total $234,000 $720,000 $234,000 $720,000 Each project requires an investment of $520,000. Straight-line depreciation will be used, and no residual value is expected. The committee has selected a rate of 10% for purposes of the net present value analysis. Present Value of $1 at Compound Interest Year 6% 10% 12% 15% 20% 1 0.943 0.909 0.893 0.870 0.833 2 0.890 0.826 0.797 0.756 0.694 3 0.840 0.751 0.712 0.658 0.579 4 0.792 0.683 0.636…arrow_forwardHelp pleasearrow_forward
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