Question

The point where a project produces a rate of return equal to the required rate of return is known as the 117 In financial breakeven, the EAC is used to (choose all that apply)

A. external breakeven point.
B. accounting profit breakeven point.
C. internal breakeven point.
D. financial breakeven point.
E. contribution margin breakeven point.
F. allocate depreciation over the life of a project.
G. determine the tax benefit of depreciation.
H. allocate the initial investment over the life of a project.
I. determine the ideal contribution margin.
J. ascertain the appropriate discount rate.

Answer 1

The point where a project produces a rate of return equal to the required rate of return is known as the

Internal breakeven point,

Financial breakeven point,

Contribution margin breakeven point.

Example:

A project of initial investment $100,000 and annual inflow of $25,000

at the end of the year, for next 6 years.

At 12%, NPV = (25,000*PVAF_{(12%, 6y)} ) – 100,000

                        = (25,000*4.111) – 100,000

                        = 102,775 – 100,000

                        = 2,775

At 13%, NPV = (25,000*PVAF_{(13%, 6y)} ) – 100,000

                        = (25,000*3.998) – 100,000

                        = 99,950 – 100,000

                        = -50

IRR = L + A / (A – B) * (H – L)

L = Lower discount rate at which NPV is +ve

H = Higher discount rate at which NPV is -ve

A = NPV at lower discount rate, L

B = NPV at higher discount rate, H

IRR = L + A / (A – B) * (H – L)

IRR = 12% + 2,775 / (2,775 – (-50)) * (13-12)

IRR = 12% + 2775 / 2825 *1

IRR = 12 + 0.9823

IRR = 12.98%

IRR of the project is 12.98%

Equivalent Annual Cost (EAC) is used to analyze two or more projects with different lifespans and the costs are very relevant.

EAC is equal to Net Present Value (NPV) divided by the present value annuity factor, taking into account r, the cost of capital and t, the number of years.

Machine A has an initial investment of $110,000, an expected lifespan of three years and an annual maintenance expense of $11,000.

Machine B has an initial investment of $180,000, an expected lifespan of five years and an annual maintenance expense of $9,000.

The cost of capital for the firm is 5%.

PVAF (5%, 3y) = 2.7232

PVAF (5%, 5y) = 4.3295

EAC (Machine A) = $110,000 / 2.7232 +$11,000

EAC (Machine A) = 40,394 + 11,000 = $51,394

EAC (Machine B) = $180,000 / 4.3295 +$11,000

EAC (Machine B) = 41,575 + 9,000 = $50,575

We have to make a capital budgeting decision where cost is the only factor.

We will select Machine B because it has a lower EAC ($819 lower than Machine A).