Question

mangerial

Problem 1 (25 points). New Mexico Company is evaluating a project requiring a capital expenditure of $750,000. The project has an estimated life of six years with a $30,000 salvage value. The estimated cash flows from this project are provided below. NEW MEXICO COMPANY DATA FOR EVALUATING CAPITAL INVESTMENT PROJECT Cash Expenses Cash Revenues Year 300,000 500,000 S S 1 390,000 600,000 2 470,000 650,000 3 420,000 600,000 4 375,000 550,000 5 270,000 500,000 6 The company depreciates its assets using the 200 % declining balance depreciation method. Management of the company expects its capital investments to earn a 15 % minimum rate of return and to payback the investment in 4.0 years or less on a before tax basis. On an after tax basis, the company expects capital investments to earn an 11 % minimum rate of return witha payback period of 5.5 years or less. The company's effective tax rate is 40 % . Calculate the following items for this capital investment project. Average accounting rate of return on an after tax basis. Round your answer to four decimal places. REQUIRED: (1) (a) Cash payback period on a before tax basis. (b) Net present value on an after tax basis. Round all present value calculations to the nearest whole dollar. Should the company invest in this project? Provide adequate support for your (c) (2) answer.

Answer 1

Depreciation rate: Twice the st. line rate

St.line line rate*2= 1/6*2==

33.33%

Depreciable base = 750000

upto $ 30000(salvage value)

is reached

Workings on Depreciation :
Year	Depn. Exp.	Asset bal.
0		750000
1	249975	500025
2	166658	333367
3	111111	222256
4	74078	148178
5	49388	98790
6	32927	65863
	Salvage	30000
	Loss on salvage	35863
	Tax saved on loss	14345
	After-tax salvage	44345

After-tax NPV & P/B
Year	0	1	2	3	4	5	6
1.Initial Investment	-750000
2.After-tax salvage(Ref. wkgs.)							44345
3.Cash revenues		500000	600000	650000	600000	550000	500000
4.Cash expenses		-300000	-390000	-470000	-420000	-375000	-270000
5.Depn. Exp.(Ref.Wkgs.)		-249975	-166658	-111111	-74078	-49388	-32927
6.EBT(3+4+5)		-49975	43342	68889	105922	125612	197073
7. Tax at 40%(6*40%)		19990	-17337	-27556	-42369	-50245	-78829
8. EAT(6+7)		-29985	26005	41333	63553	75367	118244
9.Add back;Depn.(Row 5)		249975	166658	111111	74078	49388	32927
10.Opg. Cash flows(8+9)		219990	192663	152444	137631	124755	151171
11. FCFs(1+2+10)	-750000	219990	192663	152444	137631	124755	195516
12.PV F at 11% MARR(1/1.11^Yr.n)	1	0.90090	0.81162	0.73119	0.65873	0.59345	0.53464
13.PV at 11%(11*12)	-750000	198189	156370	111466	90662	74036	104531
14.NPV at 11%(sum of row 13)	-14746
(ANSWER: c)
IRR(of row 11)	10.27%

Before-tax CFs -- NPV & P/B
Year	0	1	2	3	4	5	6
1.Initial Investment	-750000
2.before-tax salvage							30000
3.Cash revenues		500000	600000	650000	600000	550000	500000
4.Cash expenses		-300000	-390000	-470000	-420000	-375000	-270000
5.Before-tax cash flows	-750000	200000	210000	180000	180000	175000	260000
6..PV F at 15% MARR(1/1.15^Yr.n)	1	0.86957	0.75614	0.65752	0.57175	0.49718	0.43233
7.PV at 15%(11*12)	-750000	173913	158790	118353	102916	87006	112405
8.NPV at 15%(sum of row 7)	3383
9.Payback period=
Cumulative BT cash flows	-750000	-550000	-340000	-160000	20000	195000	455000
Pay back period of BT cash flows=
3+(160000/180000)=
3.89
Years
(ANSWER : b)
IRR (of row 5)	15.16%
> MARR 15%

a. Average a/cg. Rate of return on after-tax basis:
8. EAT(6+7) (from 1st table)		-29985	26005	41333	63553	75367	118244
Average a/cg.return= Sum/6
		49086
Av. Investment= (Beg.inv.value+End.Inv.value)/2
(750000+30000)/2=	390000
Average a/cg. Rate of return= Av. A/cg. Return/Av.Investment
49086/390000=	12.5862%

2..NO. As the second criteria ,of after-tax parameters , are not satisfied--as explained below:

the project just meets the criteria set for before-tax cash flows

ie. NPV at 15% is a POSITIVE $ 3383

pays back within the set 4 yrs. (3.89 yrs.) &

IRR 15.16% > MARR 15%

But

the project does not meet any of the criteria set for after-tax cash flows

ie. NPV at 11% is NEGATIVE , $ 14746

so, does not pays back within the life of the project, ie. 6 yrs.

IRR 10.27 % < MARR 11%