10-3 CORPORATE INCOME TAXES 441 5. Use the portfolio technique to analyze the fo
ID: 2481514 • Letter: 1
Question
10-3 CORPORATE INCOME TAXES 441 5. Use the portfolio technique to analyze the following choices. Using future worth as the criteria use the portfolio technique to choose between (a) A Certificate of Deposit with a return of 6% per year which must be held for 8 years. (b) A Passbook Saving Account which can be added to at any time is available at a 3% per year interest rate (not a standalone choice). (c) Investment A, Initial Cost 500,000. Increased Net Revenue 400,000 per year each year for 8 years. Salvage Value 30,000 at 8 years. (d) Investment B, Initial Cost 400,000. Increased Net Revenue 350,000 per year each year for 8 years. Salvage Value 20,000 at 8 years. Total Capital 800,000. All funds not used in initial investment put into Certificate of Deposit. Passbook savings receives cash flow funds as is normal for portfolio technique.Explanation / Answer
Answer
Option (a) A Certificate of deposit return : 6% p.a.
Option (b) : A Pass book Saving Account return : 3% p.a.
Option (c)
Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.
We have to find IRR by assuming different discount rates by trial and error method.
Suppose discount Rate is 79.2955%
Figures in $
Year
Incremental net revenue
Investment
Cash
flow
Disc Rate : 79.2955%
Present value
A
B
C
D
A+B
C*D
0
-500000
-500000
1
-500000
1
400000
400000
0.557738
223095.39
2
400000
400000
0.311072
124428.89
3
400000
400000
0.173497
69398.778
4
400000
400000
0.096766
38706.369
5
400000
400000
0.05397
21588.031
6
400000
400000
0.030101
12040.476
7
400000
400000
0.016789
6715.4368
8
400000
30000
430000
0.009364
4026.3668
Net present value
0
IRR
79.2955%
So Internal rate of return on Investment A is 79.2955%
Option (d)
Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.
We have to find IRR by assuming different discount rates by trial and error method.
Suppose discount Rate is 86.9425%
Figures in $
Year
Increased net Revenue
Investment
Cash
flow
Disc Rate : 86.9425%
Present value
A
B
C
D
A+B
C*D
0
-400000
-400000
1
-400000
1
350000
350000
0.534924
187223.34
2
350000
350000
0.286144
100150.23
3
350000
350000
0.153065
53572.746
4
350000
350000
0.081878
28657.339
5
350000
350000
0.043799
15329.494
6
350000
350000
0.023429
8200.1117
7
350000
350000
0.012533
4386.4352
8
350000
20000
370000
0.006704
2480.4893
Net present value
0
IRR
86.9425%
Internal rate of return on investment B is 86.9425%.
Answer : IRR of Investment B is higher than IRR of Investment A. So 400,000 should be invested in Investment B out of $ 800,000. Remaining $ 400,000 should be invested in Certificate of deposit.
Figures in $
Year
Incremental net revenue
Investment
Cash
flow
Disc Rate : 79.2955%
Present value
A
B
C
D
A+B
C*D
0
-500000
-500000
1
-500000
1
400000
400000
0.557738
223095.39
2
400000
400000
0.311072
124428.89
3
400000
400000
0.173497
69398.778
4
400000
400000
0.096766
38706.369
5
400000
400000
0.05397
21588.031
6
400000
400000
0.030101
12040.476
7
400000
400000
0.016789
6715.4368
8
400000
30000
430000
0.009364
4026.3668
Net present value
0
IRR
79.2955%
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