Chapter 7 Problem 14 A company is considering two alternative methods of produci

Question

Chapter 7 Problem 14 A company is considering two alternative methods of producing a new product. The relevant data concerning the alternatives appear 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 4 yrs 6 yrs 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 the discount rate is 10 percent. a. Calculate the net present value of each alternative. b. Calculate the benefit cost ratio for each alternative. c. Calculate the internal rate of return for each alternative. d. If the company is not under capital rationing which alternative should be chosen? Why? e. Again assuming no capital rationing, suppose the company plans to produce the product indefinitely rather than quit when the equipment wears out. Which alternative should the company select? Why? f. If the company is experiencing severe capital rationing, and plans to terminate production when the equipment wears out, would any of your answers above change? Chapter 7 Problem 14 A company is considering two alternative methods of producing a new product. The relevant data concerning the alternatives appear 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 4 yrs 6 yrs 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 the discount rate is 10 percent. a. Calculate the net present value of each alternative. b. Calculate the benefit cost ratio for each alternative. c. Calculate the internal rate of return for each alternative. d. If the company is not under capital rationing which alternative should be chosen? Why? e. Again assuming no capital rationing, suppose the company plans to produce the product indefinitely rather than quit when the equipment wears out. Which alternative should the company select? Why? f. If the company is experiencing severe capital rationing, and plans to terminate production when the equipment wears out, would any of your answers above change?

Explanation / Answer

Chapter 7 Problem 14

Alternative I

Note:Present value of an annuity of one $ at discount rate of 10% for 4 years is 3.170, for 6 years is 4.355. Depreciation has been added back in arriving at cash flows after tax as it is a non-cash expense.

b. Benefit Cost Ratio is calculated as Present Value of Cash Inflows/Initial Cash Outlay

Hence for Alternative I, the Benefit Cost Ratio is 72,910/64000=1.139

Similarly, for Alternative II, the Benefit Cost Ratio is 148,070/120,000=1.234

c.Calculation of Internal Rate of Return:

Alternative I

Fake payback value is calculated as Initial Cash Outlay/ Average Cash Flows $64,000/ 23,000 =2.78

Table A-4 indicates that the PV Factor nearest to 2.61 against 4 years is 2.798 and 2.743 respectively,

i.e, the rate of return lying between 16% and 17% respectively. So the IRR should be approximately 16.2%

Alternative II

Fake payback value is silmilarly calculated at $120,000/34,000=3.53. Against a period of 6 years, it lies between 17% and 18%. It would be fair to say that the IRR for Alternative II is about 17.5%

d. If the company is not under capital rationing, the obvious choice would be Alternative II, since the Net Present Value, the Benefit Cost Ratio, and the Internal Rate of Return are higher.

e. I would again select Alternative II. After the estimated useful life is over, Alternative II is going to give net cash flows after taxes of $24,000 as against only $ 15,000 from Alternative I. Selecting Alternative II would yield higher reinvestment income also.

f. My answer remains unchaged. My argument in support is that Alternative II enjoys a higher Benefit Cost Ratio or Profitability Index.

Alternative I

Alternative II Annual Receipts $ 50,000 $ 60,000 Annual Disbursements 20,000 12,000 Earnings before depreciation 30,000 48,000 Depreciation 16,000 20,000 Earnings before tax 14,000 28,000 Income tax@50% 7,000 14,000 Earnings after tax 7,000 14,000 Add Depreciation 16,000 20,000 Cash Flows after taxes 23,000 34,000 Present Value of Cash Inflows 72,910 148,070 Initial Investment 64,000 120,000 Net Present Value 8,910 28,070

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