Question

New equipment purchase, income taxes. Ella's Bakery plans to purchase a new oven for its store. The oven has an estimated useful life of 4 years. The estimated pretax cash flows for the oven are as shown in the table that follows, with no anticipated change in working capital. Ella's Bakery has a 14% after-tax required rate of return and a 35% income tax rate. Assume depreciation is calculated on a straight-line basis for tax purposes using the initial investment in the oven and its estimated terminal disposal value. Assume all cash flows occur at year-end except for initial investment amounts. Home Insert Page Layout F Formulas Data Review View B C DDE Relevant Cash Flows at End of Each Year 0 1 2 3 ($186,000) 4 3 Initial oven investment Annual cash flow from operations liexcluding the depreciation effect) Cash flow from terminal disposal of oven 4 lles $77,000 $77,000 $77,000 $77,000 $ 6,000 5 Required: 1. Calculate (a) net present value, (b) payback period, and (c) internal rate of return. 2. Calculate accrual accounting rate of return based on net initial investment.

Answer 1

initi years ($ 186000) Computation of Net present value wpvl. Rate of return=147.4 Initial Cash Salvage Total Dive@ly1. Present value investment inflow value cashflows of cash flows $ 186.000) 1000 ($ 186,000) $65 800 $ 65,800 0.877 $57706. Go 65 800 $ 65,800 O. 769 $ 5060020 $ 65 800 $ 65,800 0.675 $ 94 415 $ 65 800 $ 6000 $ 71800 0.592 $ 4250560 Fy NPV Nipv - $ 9227.40 net present value = Present value - present value of inflows of outflows Hence, wow is $9227.40 . 2 pivif@ 144.2 Present value facton @ 144. I Amount in bracket lle ($ 186000) is cashout flow.

Working note! O Calculation on oven amount of : of Depreciation Depreciation unden S.L.M - Cost of assets a Salvage value 1ffe of oes = $ 186,000 - $ 6000 ЧЧlak = $ 180.000 S4 5 $ 45000 : Hence, amount of depreciation is $45000. 2 Calculation of cash inflow : Particulars year 1 Year 2 Year 3 Earning before $ 77000 $ 77000 $ 77000 depreciation and Tan Less: Depreciation $45000 $ 45000 $45000 Year u $ 77000 45000 Ganning before Tan $32000 $32000 $32000 $32000 Less Tam @ 35% $ 11200 $ 11 200 $ 11 200 $ 11200 Earning aften Tan $ 20,800 $ 20,800 $ 20,800 $ 20800 Add! Depreciation $45000 $ 45000$ usooo $ 45000 cash inflow $ 65,800 $ 65 800 $ 65 800 $ 65 800

1 (6) Calculation of payback period Yean . 2 3 y cashinflow $ 65800 $ 65 800 $ 65 800 & G5 800 cumulative inflow $ 65 800 $131 Goo & 197400 $ 263200 payback period : - Completed gear t Remaining cemcent o - Available amount 2 +$1,86,000 - $131600) 3 $ 65,800 s 27 ($54400 ($ 65 800 ) 2t 0,826 = 2.826 years.

(c) Calculation of IRR (Internal rate of return) IRR is is zero the discount nate at which NPV At the rate of tretorn 141 ,WP is $9227.40 Let our discount nate = 20%. Initial Jeash Salvage To yean investment inflow value Totalci Avr@noy. Mesent value of cash fluer (8186000) 1.000 $ 186 000) OS 800 65800 0.833 $ 54811.40 65800 65800 0.694 $ 45665.20 65800 1.65800 0.578 $ 38032.40 65800 $6000 $71800 0.482 I $34607.60 net present value (Nou) ($12883.40 cash outflow Amount in bracket is known as Internal rate of neturn IRR) : X HIR-LR) Lower rate Lower kate wp.u to Lower nate NPV - Highen nate) Nipiv HIR Higher nape - 20% LRF Lower nate. & 14.1 IRR = 14 +589,227.40 369227.40- (-$12883.40

IRRE 14 th $9227.40 x ($9227.40+$ 12883140 6 Flyt $9227.40 $22,110.80 x 6 - lut 2.50 = 16.50 7. (approximately) Hence , internal rate of reforn is 16.50%.. Computation of Accounting note of meteren: Accounting rate of referen! Avenage P.A.T. Avenage Investment Avenage P.AT (Profit after Tan) : (20800+908007 20800 + 2.800 $ 83200 - $21800

Average investment : Particulare Year 1 Year 2 opening investment ($186.000 $141000 year 3 $ 96000 1 yeany $51000 Less! Depreciation $45000 $usooo $45000 Isusoo. Lest! Salvagevame closing investment & 141.000 $96000 $51000 6000 nil Avenage investment $ 163 500 $ 118500 $ 73500 $255. ropening closing investment investment) Avenage investment ! = $163500+ $118 500 + $73500 $25 500 = $381000 $ 99 250 Accounting rate of return : = Avenage Profit aften fan Avenage Investment F $20,800 $95250 F 0.2183 on 21.83 4. Hence, account hate of return is 21.837.