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Allegience Insurance Company’s management is considering an advertising program that would require an initial expenditure of...

Allegience Insurance Company’s management is considering an advertising program that would require an initial expenditure of $178,740 and bring in additional sales over the next five years. The projected additional sales revenue in year 1 is $83,000, with associated expenses of $29,000. 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 $178,740 advertising cost is an expense.)

  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.

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Answer #1
Calculation of incremental cash flow for next five years is shown below
Year 1 2 3 4 5
Sales revenue $83,000 $91,300 $100,430 $110,473 $121,520
Less: Expenses $29,000 $31,900 $35,090 $38,599 $42,459
Income before taxes $54,000 $59,400 $65,340 $71,874 $79,061
Taxes -$21,600 -$23,760 -$26,136 -$28,750 -$31,625
Net income $32,400 $35,640 $39,204 $43,124 $47,437
Calculation of payback period
Year Cash flow Accumulated cash flow
0 -$178,740 -$178,740
1 $32,400 -$146,340
2 $35,640 -$110,700
3 $39,204 -$71,496
4 $43,124 -$28,372
5 $47,437 $19,065
Payback period 4 + 28372/47437
Payback period 4 + 0.59809
Payback period 4.00
Thus, payback period period is 4.60
Calculation of net present value is shown below
Year 0 1 2 3 4 5
Sales revenue $83,000.00 $91,300.00 $100,430.00 $110,473.00 $121,520.30
Less: Expenses $29,000.00 $31,900.00 $35,090.00 $38,599.00 $42,458.90
Income before taxes $54,000.00 $59,400.00 $65,340.00 $71,874.00 $79,061.40
Taxes -$21,600.00 -$23,760.00 -$26,136.00 -$28,749.60 -$31,624.56
Net income $32,400.00 $35,640.00 $39,204.00 $43,124.40 $47,436.84
Initial expenditure -$178,740.00
Free cash flow -$178,740.00 $32,400.00 $35,640.00 $39,204.00 $43,124.40 $47,436.84
Discount factor @ 10% $1.00000 $0.90909 $0.82645 $0.75131 $0.68301 $0.62092
Present value -$178,740.00 $29,454.55 $29,454.55 $29,454.55 $29,454.55 $29,454.55
Net present value -$31,467.27
Thus, net present value of advertising program is -$31,467.27
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