Question

Harper Electronics is considering investing in manufacturing equipment expected to cost $250,000. The equipment has an estimated useful life of four years and a salvage value of $25,000. It is expected to produce incremental cash revenues of $125,000 per year. Harper has an effective income tax rate of 30 percent and a desired rate of return of 10 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Required

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

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

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

5. Determine the payback period and unadjusted rate of return (use average investment), assuming that Harper 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

30% Cost of Equipment Salvage value Useful Life Incremental cash revenue $2,50.000 $25,000 4 years $1.25,000 per year Tax rate Desired return 10% Straight Line Method of Depreciation Depreciable value = 250000 - 25000 = $2,25,000 Depreciation per year = 225000/4 $56,250 Rate of Depreciation = 56250 / 225000 25.00% Particulars Year 1 Year 2 Year 3 Year 4 Opening Balance $2,50,000 $1,93.750 $1,37,500 $81,250 Depreciation -$56,250 -$56,250 -$56,250 -$56,250 Closing Balance $1,93,750 $1,37,500 $81,250 $25,000 Average Average $2,21,875 $1,65,625 $1,09,375 $53,125 $1,37,500 Double Declining Method Rate of Double Delining = SLM rate x 2 = 25% x 2 50% Particulars Year 1 Year 2 Year 3 Year 4 Opening Balance $2,50,000 $1,25,000 $62,500 $31,250 Depreciation -$1,25,000-$62,500 -$31,250 -$15,625 Closing Balance $1,25,000 $62,500 $31,250 $15,625 Average Average | $1,87,500 $93,750 $46.875 $23,438 887,891

Terminal Cash Flow Calculation

SLM $25,000 -$25,000 Particulars Salvage Value Less: WDV Profit on Sale Tax @ 30% Profit Netoff Tax DDM $25,000 -$15,625 $9,375 $2,812.50 $6,562.50 $0.00 $0.00

Cash Flows - SLM Particulars Incre. Revenues less: Depreciation Incr. Profit Before Tax less: Tax @ 30% Incr. Profit After Tax Plus: Depreciation Incr. Cashflow after Tax Year 1 Year 2 Year 3 Year 4 Average $1,25,000 $1,25,000 $1,25,000 $1,25,000 $1,25,000 -$56,250 -$56,250 -$56,250 -$56,250 -$56,250 $68,750 $68,750 $68,750 $68,750 $68,750 -$20,625 -$20,625 -$20,625 -$20,625 -$20,625 $48,125 $48,125 $48,125 $48,125 $48,125 $56,250 $56.250 $56,250 $56,250 $56,250 $1,04,375 $1,04,375 $1,04,375 $1,04,375 $1,04,375 Cash Flows - Double Declining Method Particulars Year 1 Year 2 Year 3 Year 4 Average Incre. Revenues $1,25,000 $1,25,000 $1,25,000 $1,25,000 $1,25,000 less: Depreciation -$1,25,000-$62,500 -$31,250 -$15,625 -$58,594 Incr. Profit Before Tax $0 $62,500 $93,750 $1,09,375 $66,406 less: Tax @ 30% $0-$18.750 -$28.125 -$32,813 -$19,922 Incr. Profit After Tax SO $43.750 $65.625 $76,563 $46,484 Plus: Depreciation $1,25,000 $62,500 $31,250 $15,625 $58,594 Incr. Cashflow after Tax $1,25,000 $1.06.250 $96.875 $92,188 $1,05,078

NPV Calculation - SLM Year Cash Flows PVF @ 10% DCF $1,04,375 0.9091 $94.8871 $1.04.375 0.8265 $86,266 $1,04,375 0.7514 $78,4271 $1.04.375 0.6831 $71,2991 Present Value $3,30.8791 Less: Initial Investment -$2.50,000 Net Present Value S80.879 Present Value Index (PI) SLM PI = Present value / Initial Cost PI= 330879 / 250000 PI= $1.3235 NPV Calculation - DDM Year Cash Flows PVF @ 10% DCF $1,25,000 0.9091 $1,13,638 21 $1.06.250 0.8265 $87,816 $96.875 0.7514 $72,792) 4 $92.188 0.6831) $62,973 $6,563 0.6831 $4,483 Present Value $3,41,701 Less: Initial Investment -$2,50.000 Net Present Value $91,701 Present Value Index (PI) DDM PI = Present value / Initial Cost PI= 341701 / 250000 PI = $1.3668

Payback Period (PBP) Initial Investment $2,50,000 Year SLM DDM Cum. CF CF Cum. CF Year 1 $1,04,375 $1,04,375 $1,25,000 $1,25,000 Year 2 $1,04,375 $2.08.750 $1,06,250 $2,31,250 Year 3 $1,04,375 $3.13.125 $96,875 $3,28,125 Year 4 $1,04,375 $4,17,500 $98,750 $4,26,875 For Both SLM and DDM Method the Payback Period is between 2 to 3 years, on interpolation, we can find SLM PBP = 2 + [(250000 - 208750 (313125 - 208750)] Payback Period (PBP) - SLM = 2.395 Years DDM PBP = 2 + [(250000 - 231250) (328125 - 231250)] Payback Period (PBP) - DDM 2.194 Years

Unadjusted Average rate of Return (UARR) UARR = Avg. Incr. Profit After tax / Avg. Investment SLM used: UARR - SLM = 48125 / 137500 UARR - SLM = 35.00% DDM used: UARR - DDM = 48125/87890.625 UARR - DDM = 54.76% For DDM Incremental Profit After Tax = {(0-43750+65625+76563) + 6562.5}/4 Incremental Profit After Tax= $1,92,500 Avg Incremental Profit After Tax = $48.125