Question
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A company is considering two alternative methods of producing a new product. The relevant data concerning...
A company is considering two alternative methods of producing a new product. The relevant data concerning the alternative are presented below.
| Alternative 1 | Alternative 2 | |
| Initial investment | $64,000 | $120,000 |
| Annual Receipts | $50,000 | $60,000 |
| Annual Disbursements | $20,000 | $12,000 |
| Annual Depreciation | $16,000 | $20,000 |
| Expected Life | 4 years | 6 years |
| Salvage Value | 0 | 0 |
At the end of the useful life of whatever equipment is chosen the product will discontinue. The company's tax rate is 50% and its cost of capital is 10%.
A. Calculate the Cash flow paying particular attention to the cash flow impact of taxes and depreciation.
B. Calculate the net present value of each alternative.
C. Calculate the internal rate of return for each alternative.
D. If the company can implement only one of the two alternatives, and there is no restriction on investment amount, which alternative should be chosen? Why?
Solutions
Expert Solution
| A) | ||
| calculation of annual cash flow | ||
| alternative 1 | ||
| annual receipts | 50000 | |
| less: annual disbursement | -20000 | |
| less: annual depreciation | -16000 | |
| cash flow before tax | 14000 | |
| less: tax @50% | -7000 | |
| cash flow after tax | 7000 | |
| add: annual depreciation | 16000 | |
| net annual cash flow | 23000 | |
| Alternative 2 | ||
| annual receipts | 60000 | |
| less: annual disbursement | -12000 | |
| less: annual depreciation | -20000 | |
| cash flow before tax | 28000 | |
| less: tax @50% | -14000 | |
| cash flow after tax | 14000 | |
| add: annual depreciation | 20000 | |
| net annual cash flow | 34000 |
| B) net present value | ||||||
| Alternative 1 | ||||||
| present value of cash flow = net annual cash flow*PVA @10%,4years | ||||||
| present value of cash flow = 23000*3.169865 = 72906.90 | ||||||
| initial investment = 64000 | ||||||
| net present value = 72906.90-64000 = 8906.90 | ||||||
| Alternative 2 | ||||||
| present value of cash flow = net annual cash flow*PVA @10%,6years | ||||||
| present value of cash flow = 34000*4.355261 = 148078.87 | ||||||
| initial investment = 120000 | ||||||
| net present value = 148078.87-120000 = 28078.87 |
| C) | ||||||
| present value factor = INITIAL investment/annual cash flow | ||||||
| present value factor = 64000/23000 = 2.7826087 | ||||||
| present value factor fall under 16% In present value factor table | ||||||
| therefore Internal rate of return = 16% | ||||||
| alternative 2 | ||||||
| present value factor = 120000/34000 = 3.529412 | ||||||
| present value factor fall under 18% In present value factor table | ||||||
| therefore Internal rate of return = 18% | ||||||
| D) Alternative 2 should choose by company as it has highest NPV |
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