V. Cash Flows (20 points) A company is considering two alternative methods of pr
ID: 2585693 • Letter: V
Question
V. Cash Flows (20 points) A company is considering two alternative methods of producing a new product. The relevant data concerning the alternatives are presented below. Initial Investment Annual Cash Receipts Annual Cash Disbursements25,000 Annual Depreciation Expected Life (years) Salvage Value Alternative I $ 60,000 $ 70,000 Alternative II $120,000 $ 80,000 32,000 $ 20,000 $ 10,000 $0- At the end of the useful life of either the product will be discontinued. The company's tax rate is 40 percent and its cost of capital is 10 percent. a. Calculate the annual cash flows for each investment. b. Calculate the net present value of each alternative. c. Calculate the internal rate of return for each alternative. d. If the projects are independent, and there is no capital rationing, which alternative(s) should be chosen? e. If the projects are mutually exclusive, due to capital rationing, which alternative(s) should be chosen?Explanation / Answer
a). Solution :- Calculation of annual cash flows :-
Alternative I :-
Annual cash receipts
(-) Annual cash disbursement
70000
25000
Earnings before depreciation, interest and tax (EBDIAT)
(-) Depreciation
45000
10000
Earnings before interest tax (EBIT)
(-) Interest
35000
0
Earnings before tax
(-) Tax (40 % of 35000)
35000
14000
Net income
(+) Depreciation
21000
10000
Alternative II :-
Annual cash receipts
(-) Annual cash disbursement
80000
32000
Earnings before depreciation, interest and tax (EBDIAT)
(-) Depreciation
48000
20000
Earnings before interest tax (EBIT)
(-) Interest
28000
0
Earnings before tax
(-) Tax (40 % of 28000)
28000
11200
Net income
(+) Depreciation
16800
20000
Conclusion :-
b). Solution :- Net present value = Present value of cash inflows - Present value of cash outflow.
Alternative I :-
Present value of cash inflows = 31000 * [ 1 - (1.10)-6 ] / 0.10
= 31000 * [ 1 - 0.5645 ] / 0.10
= 31000 * 0.4355 / 0.10
= 31000 * 4.355
= $ 135005.
Present value of cash outflow (initial investment) = 60000.
Net present value of Alternative I = 135005 - 60000
= $ 75005.
Alternative II :-
Present value of cash inflows = 36800 * [ 1 - (1.10)-6 ] / 0.10
= 36800 * [ 1 - 0.5645 ] / 0.10
= 36800 * 0.4355 / 0.10
= 36800 * 4.355
= $ 160264.
Present value of cash outflow (initial investment) = 120000.
Net present value of Alternative II = 160264 - 120000
= $ 40264.
Conclusion :-
d). Answer :- Both the alternatives i.e., Alternative I and Alternative II should be choosen.
e). Answer :- Alternative I should be choosen because the net present value (NPV) of alternative I is higher / more than the net present value (NPV) of alternative II.
Particulars Amount ($)Annual cash receipts
(-) Annual cash disbursement
70000
25000
Earnings before depreciation, interest and tax (EBDIAT)
(-) Depreciation
45000
10000
Earnings before interest tax (EBIT)
(-) Interest
35000
0
Earnings before tax
(-) Tax (40 % of 35000)
35000
14000
Net income
(+) Depreciation
21000
10000
Annual cash flow 31000Related Questions
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