Question

Q#2 Impact of 2017 Tax Cut Act on Net Income, Cash Flows and 8 Capital Budgeting (Investment) De cisions 59 (a) Estimate NPV, IRR and Payback Period of the project if equipment is fully 60 depreciated in first year and tax rate equals to 21 %. Would you 61 accept or reject the project? 62 (b) As a CFO of the firm, which of the above two scenario (a) or (b) 63 would you choose? Why?

Answer 1

Answer with working is given below

For Scenario 2 it is assumed tax loss is not refunded

Q. No.1 CFOL CF4 CF1 1 CF2 2 CF3 3 4 Investments Equipment Cost Shipping and Install cost Start up expenses Total Basis cost Net Working Capital Total Initial Cost -$200,000 -$35,000 -$5,000 -$240,000 -$20,000 -$260,000 Operations Revenue Operating cost Depreciation EBIT Taxes at 21% Net Income Add: Depreciation Total Operating Cash inflow $200,000 $120,000 $60,000 $20,000 $4,200 $15,800 $60,000 $75,800 $210,000 $126,000 $60,000 $24,000 $5,040 $18,960 $60,000 $78,960 $220,500 $132,300 $60,000 $28,200 $5,922 $22,278 $60,000 $82,278 $231,525 $138,915 $60,000 $32,610 $6,848 $25,762 $60,000 $85,762 Terminal Change in net WC Salvage value after tax Total Present value factor of 10% $20,000 $11,850 $117,612 0.6830 -$260,000 $75,800 0.9091 $78,960 0.8264 $82,278 0.7513 Present value of cash flows $260,000 $68,909 $65,256 $61,817 $80,331 NPV $16,312 IRR 12.7% Payback 3.80 years working note IRR calculation Year o Year 1 Year 2 Year 3 Year 4 -$260,000 $75,800 $78,960 $82,278 $117,612 12.7% Payback Cash flows Cumulative $68,909 $68,909 $65,256 $134,165 $61,817 $195,982 $80,331 IRR Year 4 CF Payback 0.80 3.80 years Comments Since NPV is positive the project can be accepted. The IRR of project is above cost of capital. Hence project can be accepted Since payback period is 3.80 years and cut off is 3 years project should not be accepted Q. No.2 CFO CH1 1 CH2 2 CF3 3 C F4 4 Investments Equipment Cost Shipping and Install cost Start up expenses Total Basis cost Net Working Capital Total Initial Cost -$200,000 -$35,000 -$5,000 -$240,000 -$20,000 -$260,000 $210,000 $126,000 $220,500 $132,300 $231,525 $138,915 Operations Revenue Operating cost Depreciation EBIT Taxes at 21% Net Income Add: Depreciation Total Operating Cash inflow $200,000 $120,000 $240,000 -$160,000 $84,000 $17,640 $66,360 $88,200 $18,522 $69,678 $92,610 $19,448 $73,162 -$160,000 $240,000 $80,000 $66,360 $69,678 $73,162 Terminal Change in net WC Salvage value after tax Total Present value factor of 10% $20,000 $11,850 $105,012 0.6830 -$260,000 $80,000 0.9091 $66,360 0.8264 $69,678 0.7513 Present value of cash flows $260,000 $72,727 $54,843 $52,350 $71,725 NPV $8,355 IRR 8.6% Payback 3.42 years working note IRR calculation Year o Year 1 Year 2 Year 3 Year 4 IRR -$260,000 $80,000 $66,360 $69,678 $105,012 8.6% Payback Cash flows Cumulative $80,000 $80,000 $66,360 $146,360 $69,678 $216,038 $105,012 Year 4 CF Payback 3.42 years The project should be rejected since NPV is negative and IRR % is below cost of capital Payback period is also above 3 years b) As a CFO Scenario a) is preferable since NPV is positive and IRR is above cost of capital