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 40 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.

Answer 1

Answer 2

Year	Increase in Sales	Increase in Exp	Net Increase in Income	After tax cash inflow	PVIF @ 10%	PV of net cash inflows
1	75000	25000	50000	30000	0.90909	27,273
2	82500	27500	55000	33000	0.82645	27,273
3	90750	30250	60500	36300	0.75131	27,273
4	99825	33275	66550	39930	0.68301	27,273
5	109807.5	36602.5	73205	43923	0.62092	27,273
Total						1,36,364

Initial Investment in advertisement expense	1,65,500
Initial Investment in advertisement expense (net of tax)	99,300
PV of Cash Inflows (as calculated above)	1,36,364
Net Present Value	37,064

Answer 1

Year	After tax cash inflow	Cumulative cash inflow
1	30000	30000
2	33000	63000
3	36300	99300
4	39930	139230
5	43923	183153

Cumulative net cash flow after tax for 3 years is 99,300 (i.e after tax amount of initial expenditure). Thus payback period is 3 years