Financial & Managerial Accounting
Fall 2011
Homework #6 DUE: Thursday, Nov. 3rd
1. You hope to retire in 40 years. You’ve figured that you’ll need $300,000 at the end of 40 years in order to retire. You are attempting to figure out different possibilities for retirement. Answer the following scenarios.
a. You place $25,000 into an account that pays an annual interest rate of 6%. Will you be able to retire?
b. Assuming you’ll need $300,000 to retire and can earn a 6% interest rate on a deposit, how much would you need to deposit today in order to retire in 40 years?
c. Assuming you actually did only have $25,000 today and still wanted to retire in 40 years with $300,000, what interest rate would you need to earn in order to make it all happen?
2. Two investment options are expected to have the following payouts in the coming years. Assuming the appropriate discount rate is 7% for both options, determine their present value.
End of Year / Option 1 / Option 21 / 110 / 40
2 / 120 / 50
3 / 70 / 70
4 / 50 / 110
5 / 40 / 120
3. Lulu uses the Net Present Value (NPV) method when deciding upon investment projects. Currently, Lulu is weighing an option to open a new store. They know that the initial cost of opening the store will be $30 million. They anticipate that the new store will generate the following additional profit over the next several years.
End of Year / Profits from New Store (in millions)1 / 1.5
2 / 2.5
3 / 4.5
4 / 5.8
5 / 6.2
6 / 9.5
7 / 10.5
8 / 11.5
Assuming LULU uses a 12% cost of capital (i.e., appropriate discount rate), should they invest in the new store?
4. A large corporation is considering acquiring a smaller business. The owner of the small business will only sell for a cash payment of $45 million. The larger corporation estimates that by acquiring the business, it will be able to generate $5.5 million per year forever. The corporation uses the Internal Rate of Return (IRR) method for making these types of investment decisions. Assuming a cost of capital of 12%, should the corporation acquire the smaller business?
5. Intel is considering purchasing a piece of equipment that will only last one year. The equipment costs $70,000. Intel believes that the equipment will add $90,000 to their profits next year. Finally, Intel uses a 9% cost of capital (i.e., appropriate discount rate).
A. Using the NPV method, determine whether Intel should make the investment.
B. What is the internal rate of return (IRR) for this investment?
C. Redo parts A and B but assume the $90,000 will actually occur in 4 years (it still only adds profit in that one year which is now 4 years away). Thus, assume that the equipment will not actually be in operations until 4 years out, but it will still cost $70,000 now.