A project has an initial cost of $159,000 and an estimated salvage value after 14 years of $74,000. Estimated average annual receipts are $31,000. Estimated average annual disbursements are $16,000. Assuming that annual receipts and distributions will be uniform for the 14 years, compute the prospective rate of return before taxes.
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To compute the prospective rate of return before taxes, we can use the net cash flow approach.
1. Calculate the average annual net cash flow:
Annual net cash flow = Average annual receipts - Average annual disbursements
Annual net cash flow = $31,000 - $16,000
Annual net cash flow = $15,000
2. Calculate the total net cash flow over the project's life:
Total net cash flow = Annual net cash flow * Number of years
Total net cash flow = $15,000 * 14
Total net cash flow = $210,000
3. Calculate the average annual investment:
Average annual investment = (Initial cost - Salvage value) / Number of years
Average annual investment = ($159,000 - $74,000) / 14
Average annual investment = $7,500
4. Calculate the prospective rate of return:
Prospective rate of return = (Total net cash flow / Average annual investment) * 100
Prospective rate of return = ($210,000 / $7,500) * 100
Prospective rate of return = 28%
Therefore, the prospective rate of return before taxes is 28%.
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