Question

Allegience Insurance Company’s management is considering an advertising program that would require an initial expenditure of $165,500 and bring in additional sales over the next five years. The projected additional sales revenue in year 1 is $75,000, with associated expenses of $25,000. The additional sales revenue and expenses from the advertising program are projected to increase by 10 percent each year. Allegience’s tax rate is 30 percent. (Hint: The $165,500 advertising cost is an expense.) Use Appendix A for your reference. (Use appropriate factor(s) from the tables provided.) Required: 1. Compute the payback period for the advertising program. 2. Calculate the advertising program’s net present value, assuming an after-tax hurdle rate of 10 percent. (Round your intermediate calculations and final answer to the nearest whole dollar.)

Answer 1

Working Note :
Calculation of Net Income earned from the project over next 5 years
Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Sales	75,000	82,500	90,750	99,825	1,09,808
Less : Expenses	-25,000	-27,500	-30,250	-33,275	-36,603
Income before tax	50,000	55,000	60,500	66,550	73,205
Less : Taxes	-15,000	-16,500	-18,150	-19,965	-21,962
Net Income after taxes	35,000	38,500	42,350	46,585	51,244
Requirement 1 : Computation of Payback Period
Year	Cash Flows (Net Income)	Cumulative CF
1	35,000	35,000
2	38,500	73,500
3	42,350	1,15,850
4	46,585	1,62,435
5	51,244	2,13,679
Payback Period = 4 + (165,500-162,435)/51,244 = 4.06 years
Requirement 2 : Net Present Value
Year	Cash Flows (Net Income)	PVF @ 10%	Present Value of Cash Flows
1	35,000	0.909	31,818
2	38,500	0.826	31,818
3	42,350	0.751	31,818
4	46,585	0.683	31,818
5	51,244	0.621	31,818
			1,59,091
		Less : Cash Outflow	-1,65,500
		NPV	-6,409
Since NPV is coming out to be negative, it is advised not to invest in this advertising program.