1) ABC is considering a new investment that will cost $50,000 to produce a new p
ID: 2563112 • Letter: 1
Question
1) ABC is considering a new investment that will cost $50,000 to produce a new product that the president of the company has invented. The marketing dept. of the company anticipates that new cash flows from the investment will be $10,000, 12,000, 12,000, 12,000 and 10,000. The newly elected President of the United States, President H. Clinton, has reinstituted the old investment tax incentive for corporations which gives an investment tax credit of 10% of the cost of an investment applicable in the second year after implementation of the investment. It will cost the company $2,000 to install the new equipment in the factory to get it going. The operations officer/engineer thinks that the residual value of the equipment will be $10,000; that maintenance costs will be $1,000 in years 2 and 4 only. The corporate controller says that the accounting dept. has been using DDB depreciation for all new equipment. Assuming the company can sell bonds at 10% to pay for this investment, is this a good investment for the company?
2) Whether it is or is not, the president of the company wants to know what the IRR is of the new investment.
Explanation / Answer
1. Investment tax credit = 10% of cost of investment = 10% of 50,000 = 5,000
Now we will compute the net present value of the above cash flows by using a discount rate of 10%. NPV = sum of all present values (PV). PV = cash flow/(1+10%)^n, where n is the year of cash flow.
As NPV<0 it is not a good investment for the company.
2. IRR = the discount rate that makes NPV as nil. It has been computed using a trial and error approach.
Thus IRR = 1.04490 - 1 = 0.04490 OR 4.49%
Year Cash flow Particulars 0 -50,000.00 Investment 0 -2,000.00 Installation cost 1 10,000.00 Cash flows from investment 2 12,000.00 Cash flows from investment 2 5,000.00 Investment tax credit 2 -1,000.00 Maintenance cost 3 12,000.00 Cash flows from investment 4 12,000.00 Cash flows from investment 4 -1,000.00 Maintenance cost 5 10,000.00 Cash flows from investmentRelated Questions
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