net present value method Flashcards
Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce annual cash operating costs by $30,000 in each of the first 2 years and by $20,000 in year 3. Present values of an annuity of $1 at 14% a
nswer (B) is correct.
The cost reductions constitute two annuities: a 3-year annuity of $20,000 per year and a 2-year annuity of $10,000 per year. Using a 14% cost of capital and ignoring tax effects, the present value of the future savings can be calculated as follows:
PV of 3-year cash savings:
$20,000 × 2.32
=
$46,400
PV of 2-year cash savings:
$10,000 × 1.65
=
16,500
Net present value
$62,900
Which one of the following items is least likely to directly impact an equipment replacement capital expenditure decision?
The net present value of the equipment that is being replaced.
Answer (B) is correct.
The only relevant valuation of existing equipment is its salvage value at the time of the decision
PAY BACK PERIOD
NET INTIAL INVESTMENT/INCERESE IN ANNUAL NET AFTER -TAX FLOW
NPV IN SHORT MEANS
DISCOUNTED CASH OUTFLOW -DISCOUNTED CASH INFLOW
CALCULATING IRR
IRR=NPV
The first step in assessing the desirability of a potential capital project is to identify the relevant cash flows, which are the future revocable cash flows.
They include (1) the cost of new equipment, (2) annual after-tax cash savings or inflows, (3) proceeds from disposal of old equipment (salvage value), and (4) adjustment for depreciation expense on new equipment (called the depreciation tax shield since it reduces taxable income and thereby reduces cash outflow for tax expense
present value of
future value/(1+r)n
Major Corp. is considering the purchase of a new machine for $5,000 that will have an estimated useful life of 5 years and no salvage value. The machine will increase Major’s after-tax cash flow by $2,000 annually for 5 years. Major uses the straight-line method of depreciation and has an incremental borrowing rate of 10%. The present value factors for 10% are as follows:
Ordinary annuity with five payments
3.79
Annuity due for five payments
4.17
Using the payback method, how many years will it take to pay back Major’s initial investment in the machine
pay back period= net intial investment/increase in annual cash flow after tax
5000/2000=2.50 years
Fact Pattern: The Frame Supply Company has just acquired a large account and needs to increase its working capital by $100,000. The controller of the company has identified the four sources of funds given below.
Pay a factor to buy the company’s receivables, which average $125,000 per month and have an average collection period of 30 days. The factor will advance up to 80% of the face value of receivables at 10% and charge a fee of 2% on all receivables purchased. The controller estimates that the firm would save $24,000 in collection expenses over the year. Assume the fee and interest are not deductible in advance.
Borrow $110,000 from a bank at 12% interest. A 9% compensating balance would be required.
Issue $110,000 of 6-month commercial paper to net $100,000. (New paper would be issued every 6 months.)
Borrow $125,000 from a bank on a discount basis at 20%. No compensating balance would be required.
Assume a 360-day year in all of your calculations
20.0%
Answer (C) is correct.
By issuing commercial paper, the company will receive $100,000 and repay $110,000 every 6 months. Thus, for the use of $100,000 in funds, the company pays $10,000 in interest each 6-month period, or a total of $20,000 per year. The annual percentage rate can therefore be calculated as follows:
Effective rate
=
Interest expense ÷ Usable funds
=
$20,000 ÷ $100,000
=
20.0%
cash flows for capital budgeting pass key
- multiply pretax cash flow by(1-taxrate)as a short cut to compute the after tax cash flows +
- multiply non tax shield items such as depreciation by the tax rate as a component of total after tax cash flows
Whatney Co. is considering the acquisition of a new, more efficient press. The cost of the press is $360,000, and the press has an estimated 6-year life with zero salvage value. Whatney uses straight-line depreciation for both financial reporting and income tax reporting purposes and has a 40% corporate income tax rate. In evaluating equipment acquisitions of this type, Whatney uses a goal of a 4-year payback period. To meet Whatney’s desired payback period, the press must produce a minimum annual before-tax operating cash savings of
. $110,000
Answer (D) is correct.
Payback is the number of years required to complete the return of the original investment. Given a periodic constant cash flow, the payback period equals net investment divided by the constant expected periodic after-tax cash flow. The desired payback period is 4 years, so the constant after-tax annual cash flow must be $90,000 ($360,000 ÷ 4). Assuming that the company has sufficient other income to permit realization of the full tax savings, depreciation of the machine will shield $60,000 ($360,000 ÷ 6) of income from taxation each year, an after-tax cash savings of $24,000 ($60,000 × 40%). Thus, the machine must generate an additional $66,000 ($90,000 – $24,000) of after-tax cash savings from operations. This amount is equivalent to $110,000 [$66,000 ÷ (1.0 – .4)] of before-tax operating cash savings.
A company invested in a new machine that will generate revenues of $35,000 annually for 7 years. The company will have annual operating expenses of $7,000 on the new machine. Depreciation expense, included in the operating expenses, is $4,000 per year. The expected payback period for the new machine is 5.2 years. What amount did the company pay for the new machine?
Answer (B) is correct.
The payback period is the number of years required for the net cash savings or inflows to equal the original investment. Payback period only considers direct cash flows, so it does not take into account the effect of depreciation or other non-cash expenses. This machine’s annual after-tax cash savings of $32,000 is calculated as the annual inflow of $35,000 decreased by the annual outflows (without regard to depreciation) of $3,000 ($7,000 – $4,000). The initial investment can be thus calculated as follows:
Initial investment ÷ Annual after-tax cash savings
=
Payback period
Initial investment ÷ $32,000
=
5.2 years
Initial investment
=
5.2 years × $32,000
Initial investment
=
$166,400
ACCOUNTING RATE OF RETURN
ANNUAL CASH FLOW-DEPRECIATION/INTIAL INVESTMENT
profitability index
PV OF FUTURE NET CASH FLOWS ORNPV OF PROJECT/INTIAL INVESTMENT
company currently has 1,000 shares of common stock outstanding with zero debt. It has the choice of raising an additional $100,000 by issuing 9% long-term debt or issuing 500 shares of common stock. The company has a 40% tax rate. What level of earnings before interest and taxes (EBIT) would result in the same earnings per share (EPS) for the two financing options?
If new debt is issued, interest expense will be $9,000 per year ($100,000 face amount × 9% coupon rate); if new common stock is issued, interest expense will continue to be zero. Thus, earnings before taxes and income available to common shareholders (the EPS numerator) will be different depending on the financing option. The EPS denominator will also be different, since there are only 1,000 common shares outstanding under the debt alternative but 1,500 outstanding under the common stock alternative. EBIT ($27,000) can be calculated from the following EPS equation:
The differing numerators and denominators result in identical results for EPS as shown in the full calculations below:
Common
Debt
Stock
Earnings before interest and taxes
$27,000
$27,000
Less: interest expense
(9,000)
0
Earnings before taxes
$18,000
$27,000
Less: income tax expense (40%)
(7,200)
(10,800)
Income available to common stockholders
$10,800
$16,200
Divided by: common shares outstanding
÷ 1,000
÷ 1,500
Earnings per share
$ 10.80
$ 10.80
