Question

A company is considering two alternative methods of producing a new product. The relevant data concerning the alternatives are presented below. Alternative I Alternative 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 4 years 6 years Salvage value 0 0 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. Calculate the Cash flow paying particular attention to the cash flow impact of taxes and depreciation, Calculate the net present value of each alternative. Calculate the internal rate of return for each alternative. 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?

Answer 1

Answer:

Cash flow>

One 15,000 per year

Two 24,000 per year

NPV>

one -16,452

two  -15,474

As both options make a negative cashflow

none of them are viable considering a cost of capital of 10%

Explanation:

$\left[\begin{array}{cccc}&One&Two&Differential\\ Receipts&50000&60000&10000\\ Expenses&-36000&-32000&4000\\ Before tax&14000&28000&14000\\ Tax&-7000&-14000&-7000\\ Dep tax shield&8000&10000&2000\\ Cash flow&15000&24000&9000\\\end{array}\right]$

Net present value for each alternative>

First>

$\left[\begin{array}{ccc}Year&cash-flow&PV\\0&-64000&-64000\\1&15000&13636\\2&15000&12397\\3&15000&11270\\4&15000&10245\\\\Total&&-16452\\\end{array}\right]$

Second>

$\left[\begin{array}{ccc}Year&cashflow&PV\\0&-120000&-120000\\1&24000&21818\\2&24000&19835\\3&24000&18032\\4&24000&16392\\5&24000&14902\\6&24000&13547\\Total&&-15474\\\end{array}\right]$