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BADM.3253: MGMT ANALYSIS & CONTROL M.3253: MGMT ANALYSIS & CONTROL Problem Sets Problem Set 4: Chalk & Wire Assessment BADM 3253 SLO12 A company is considering two alternative methods of producing a new product. The relevant data concerning the alternatives are presented below. Alternative Alternative I II Initial investment $64,000 $120,000 Annual receipts $50,000 $60,000 Annual disbursements $20,000 $12,000 Annual depreciation $16,000 $20,000 Expected life 6 years Salvage value 0 0 4 years At the end of the useful life of whatever equipment is chosen the product will be discontinued. The company's tax rate is 50 percent and its cost of capital is 10 percent. 1. Calculate the cash flow paying particular attention to the cash flow impact of taxes and depreciation, 2 Calculate the net present value of each alternative. 3. Calculate the internal rate of return for each alternative. 4. If the company can implement only one of the two alternatives, and there is no restriction on investment amount, which alternative should be chosen? Why? BADM 3253 SLO 1.3 Instructions; Analyze the attached Balance Sheet and Income statement, calculating and interpreting the following ratios, and making a conclusion on the financial position of the company addressing the 3 financial categories. Profitability Ratios (in %): Return on equity. Return on assets, Return on invested capital, Profit margin, Gross margin Turnover-Control Ratios; Asset turnover, Fixed-asset turnover, laventory turnover, Collection period (davsl Davs' sales in cash. Pavables period

Answer 1

1)

Cash flow of Alternative 1

There is no change in cash flow for the project throughout its life.

Cash Receipts $50,000

Cash Payments $20,000

Depreciation $16,000

Profit $14,000

Tax @ 50% $ 7,000

Net Profit $ 7,000

Add Back

Depreciation $16,000

Cash flow $23,000

There will be no change in $23,000 throughout the life of the project.

Alternative 2

Cash Receipts $60,000

Cash Payment $12,000

Depreciation $20,000

Profit $28,000

Tax @ 50% $14,000

Net Profit $14,000

Add Back

Depreciation $20,000

Cash flow $34,000

There will be no change for this $34,000 of cash flow throughout the life of the project.

2)

NPV of Alternative 1

Discount Rate 10%

Present value of future cash flows:-

$23,000*3.170 (Refer present value of annuity table)

= $72,910

NPV = Present value of future cash flow -

Initial Investment

= $72,910-$64,000

= $8,910

NPV of Alternative 2

Present value of Cash flow is:-

$34,000*4.355 (Refer PV of annuity Table)

= $148,070

NPV = $148,070-$120,000

= $28,070

3)

IRR of Alternative 1

IRR is the rate where NPV = 0

For this we have to find out the fake payback period.

Payback = Initial Investment/Annual Cash flow

= $64,000/$23,000

= 2.78

This is just a hint to find where will be that rate.

Now once again refer PV annuity table and check where does 2.78 comes under 4 year period. It comes under 16%.(Approximately near one should be selected)

Now lets calculate the NPV under 16%

$23,000*2.798

= $64,354

So NPV = $64,354-$64,000

= $354

We didn't get the NPV as 0 So let's calculate NPV under 17% too

NPV under 17%

= $23,000*2.743

= $63,089

So NPV = $63,089-$64,000

= -$911

Now we have a negative NPV so we can conform that the IRR is between 16% & 17%

IRR =

LR + NPV @ LR/(NPV @ LR - NPV @ HR)*HR-LR

Where,

LR is Lowest Rate

HR is Highest Rate

IRR=16+$354/($354- -$911)* 17-16

= 16+$354/1265 *1

= 16+.28

= 16.28%

Always remember that NPV @ HR will be a negative figure and in equation we have to less NPV @ LR - NPV @ HR. So both Negatives will form a positive figure.

IRR of Alternative 2

Fake payback = $120,000/$34,000

= 3.529

Refer and find where does 3.529 comes under 6 years period. It comes under 17% (Approximately)

NPV under 17%

$34,000*3.589

= $122,026

NPV = $122,026-$120,000

= $2,026

Now lets Calculate NPV under 18%

$34,000*3.498

= $118,932

NPV = 118,932-$120,000

= -$1,068

IRR = 17 + $2,026/($2,026 - -$1,068) * 18-17

= 17 + $2,026/3,094 * 1

= 17 + .65

IRR = 17.65

4)

The most accurate measure to select a project is by checking NPV. But it has a limitation that if the initial investment is not equal then NPV can't ne used to selecte a project it may sometimes reduces the shareholders wealth. So we have find the profitability index for the both projects

Profitability Index (P.I) of Alternative 1

P.I = NPV/Initial Investment

= $8,910/$64,000

= .14 or 14%

Profitability Index of Alternative 2

P.I = $28,070/$120,000

= .23 or 23%

Here by NPV & by P.I Alternative 2 is good for the company and company should select that.

Note: I have tried to upload the PV of Annuity table but due some technical issues it hasn't uploaded. If you don't have it then just search Present value of annuity table pdf on google.