Question

A new equipment would provide annual cash savings of $84 000 before income taxes.

The equipment would cost $216 000 and have an estimated useful life of five years.

The equipment is expected to have no salvage value at the end of five years.

Straight-line depreciation method is used for all equipment for both accounting and tax purposes.

TAX RATE : 40% After-tax required rate of return: 12%

1. For investment in new equipment, calculate the after-tax:

a) payback period

b) accounting rate of return

c) net present value

d) profitability index

e) internal rate of return

(Assume that all operating revenues and expenses occur at the end of the year.)

2. Identify and discuss the issues that COMPANY management should consider when deciding which of the five techniques identified in requirement 1 should be employed to evaluate alternative capital investment projects

Answer 1

Initial Cost = $216,000

Salvage Value = 0

Useful Life = 5 years

Annual Depreciation = (216000-0)/5 = $43,200

Before-tax annual Cash Savings = $84,000

Tax Rate = 40%

Before-tax cash saving	$84,000.00
Less: Depreciation	$43,200.00
Before-tax net saving	$40,800.00
Tax	$16,320.00
Net Income	$24,480.00
Net Cash Flow	$67,680.00

Hence, annual net cash flow = $67,680

a) Payback period = Initial Cost/Annual net cash flow = 216000/67680 = 3.19 years

b) Accounting rate of return = Accounting Income/Initial Investment = 24480/216000 = 11.33%

Accounting rate of return is also defined as = accounting income/average investment

Average investment = (Initial Investment + Salvage Value)/2 = (216000+0)/2 = 108000

Hence, Accounting rate of return = 24480/108000 = 22.67%

c) Net present value = -216000 + 67680*((1-(1+12%)^-5)/12%) = $27,971.25

d) Profitability index = (NPV+Initial Investment)/Initial Investment = ($27,971.25+216000)/216000

PI = 1.13

e) Let Internal rate of return be ‘i’, then,

NPV = -216000 + 67680*((1-(1+i)^-5)/i) = 0

For i = 17%, NPV = 531.75

For i = 18%, NPV = -4353.07

Hence IRR = 17%+(18%-17%)*(0-531.75)/(-4353.07-531.75) = 17.11%

2. Company management should consider below listed factors while deciding the technique of capital budgeting:

a) Company’s liquidity: If a company is facing liquidity issues, company may prefer to go for a project with a shorter payback period. However, if there is no such issue, company can choose the project basis its profitability.

b) Availability of resources: If a company has limited resources (most importantly capital), then they need to utilize it for the potential value addition to the company. In such cases, NPV & PI techniques are best utilized.

c) Re-investment of cash flows of the project: Company management also need to consider where & how the cash flows generated of the project would be re-invested and need to identify re-investment rate.