Question

Vernon Electronics is considering investing in manufacturing equipment expected to cost $370,000. The equipment has an estimated useful life of four years and a salvage value of $ 21,000. It is expected to produce incremental cash revenues of $185,000 per year. Vernon has an effective income tax rate of 40 percent and a desired rate of return of 14 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.) Required Determine the net present value and the present value index of the investment, assuming that Vernon uses straight-line depreciation for financial and income tax reporting. Determine the net present value and the present value index of the investment, assuming that Vernon uses double-declining-balance depreciation for financial and income tax reporting. Determine the payback period and unadjusted rate of return (use average investment), assuming that Vernon uses straight-line depreciation. Determine the payback period and unadjusted rate of return (use average investment), assuming that Vernon uses double-declining-balance depreciation. (Note: Use average annual cash flow when computing the payback period and average annual income when determining the unadjusted rate of return.)

Answer 1

Answer :

Determine the net present value and the present value index of the investment, assuming that Vernon uses straight - line depreciation for financial and income tax reporting.

Cost	370000
Salvage value	21000
Life	4 years
Depreciation = (370000 - 21000)/4	87250
Incremental cash revenues	185000
Depreciation	-87250
	97750
Less: Tax 40%	39100
EAT	58650
Add : Depreciation	87250
Cash Flow	145900

NPV = - 370000+145900*(PVIFA 14%, 4 years)+21000*(PVIF 14%,4 yrs)

NPV= -370000+145900*(2.912)+21000*(0.592)

NPV = 67292.80

Present value index = (67292.80 + 370000)/370000 = 1.18

Determine the net present value and the present value index of the investment, assuming that Vernon uses double -declining - balance depreciation for financial and income tax reporting.

DDB Schedule

2* Straight - line depreciation rate * Book value at the beginning of the year

2*1/4* Book value

Year	Beginning Book Value	Depreciation	Ending Book Value
1	370000	185000	185000
2	185000	92500	92500
3	92500	46250	46250
4	46250	23125	23125

Year	Cash Rev.	Depre	Net Rev.	Tax @40%	Depre + EAT	Cash flow	PVF @14%	PV
0						-370000	1	-370000
1	185000	185000	0	0	185000	185000	0.877	162245
2	185000	92500	92500	37000	148000	148000	0.769	113812
3	185000	46250	138750	55500	129500	129500	0.674	87283
4	185000	23125	161875	64750	120250	120250	0.592	71188
							NPV	64528

Present value index = (64528 + 370000)/370000 = 1.17

Determine the payback period and unadjusted rate of return (using average investment), assuming that Vernon uses straight - line depreciation.

Year	Cash Flow	Cumm. Cash flow
0	-370000	-370000
1	145900	-224100
2	145900	-78200
3	145900
4	145900

Payback period = 2yrs + 78200/145900 =2.54 years

Unadjusted rate of return = 58650/(0+370000)/2 = 31.7%

Determine the payback period and unadjusted rate of return (use average investment), assuming that Vernon uses double - declining - balance depreciation

Average income = (0+55500 + 83250 + 97125 ) / 4 = 58968.75

Average investment = 370000 / 2 = 185000

Unadjusted rate of return =58968.75 / (0 + 370000 )/2 = 31.88%

Average cash flow = (185000 +148000 +129500 + 120250 )/4 = 145687.50

Payback period = 370000/145687.50 = 2.54 years.