Question

Fanning Electronics is considering investing in manufacturing equipment expected to cost $250.000. The equipment has an estimated useful life of four years and a salvage value of $ 19,000. It is expected to produce incremental cash revenues of $125,000 per year. Fanning has an effective income tax rate of 40 percent and a desired rate of return of 12 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.) Required a. Determine the net present value and the present value index of the investment, assuming that Fanning uses straight-line depreciation for financial and income tax reporting b. Determine the net present value and the present value index of the investment, assuming that Fanning uses double-declining- balance depreciation for financial and income tax reporting d. Determine the payback period and unadjusted rate of return (use average investment), assuming that Fanning uses straight-line depreciation e. Determine the payback period and unadjusted rate of return (use average investment), assuming that Fanning uses double declining balance depreciation (Note Use average annual cash flow when computing the payback period and average annual income when determining the unadjusted rate of return)

Answer 1

Depreciation in Straight-Line Method: = ($250,000 - $19,000) / 4 years = $231,000 / 4 years = $57,750.00 Year Depreciation under double declining method: Depreciation rate = 1/ 4 years = 25% Double Declining Depreciation rate = 25%*200% = 50% Depreciation Closing Opening balance Depreciation rate balance 1 $2,50,000.00 50.00% $1,25,000.00 $1,25,000.00 2 $1,25,000.00 50.00% $62,500.00 $62,500.00 3 $62,500.00 50.00% $31,250.00 $31,250.00 4 $31,250.00 50.00% $15,625.00 $15,625.00 Details when Depreciation under Straight Line Method: Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Initial Investment -$2,50,000.00 Revenue $1,25,000.00 $1,25,000.00 $1,25,000.00 $1,25,000.00 Less: Depreciation $57,750.00 $57,750.00 $57,750.00 $57,750.00 EBT $67,250.00 $67,250.00 $67,250.00 $67,250.00 Less:Tax @40% $26,900.000 $26,900.00 $26,900.00 $26,900.00 Profit after tax $40,350.00 $40,350.00 $40,350.00 $40,350.00 Add: Depreciation $57,750.00 $57,750.00 $57,750.00 $57,750.00 Cash Flows $98,100.00 $98,100.00 $98,100.00 $98,100.00 Add: Salvage Value $19,000.00 Net Cash flows $2,50,000.00 $98,100.00 $98,100.00 $98,100.00 $1,17,100.00 PVF @ 12% 1.0000 0.8929 0.7972 0.7118 0.6355 Present Value of cash flows -$2,50,000.00 $87,593.49 $78,205.32 $69,827.58 $74,417.05 NPV of the Project = $60,043.44 Details when Depreciation under Straight Line Method: Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Initial Investment -$2,50,000.00 Revenue $1,25,000.00 $1,25,000.00 $1,25,000.00 $1,25,000.00 Less: Depreciation $1,25,000.00 $62,500.00 $31,250.00 $15,625.00 EBT $0.00 $62,500.00 $93,750.00 $1,09,375.00 Less:Tax @40% $0.00 $25,000.00 $37,500.00 $43,750.00 Profit after tax $0.00 $37,500.00 $56,250.00 $65,625.00 Add: Depreciation $1,25,000.00 $62,500.00 $31,250.00 $15,625.00 Cash Flows $1,25,000.00 $1,00,000.00 $87,500.00 $81,250.00 Add: Salvage Value * $17,650.00 Net Cash flows -$2,50,000.00 $1,25,000.00 $1,00,000.00 $87,500.00 $98,900.00 PVF @ 12% 1.0000 0.8929 0.7972 0.7118 0.6355 Present Value of cash flows -$2,50,000.00 $1,11,612.50 $79,720.00 $62,282.50 $62,850.95 NPV of the Project = $66,465.95 (* After tax Salvage Value = $19,000 - ($19,000 - $15,625) *40% = $17,650.00 Present Value of Index : Cash inflows / Cash outflows Present Present Present Value Index: value of Cash value of Cash Inflows outflows a) $3,10,043.44 $2,50,000.00 b) $3,16,465.95 $2,50,000.00 Present Value of Index 1.24 1.27 Payaback Period: a) = 2 years + $53,800/$98100 = 2 years +0.55 years = 2.55 years b) = 2 years + $25,000 / $87,500 = 2 years + 0.29 years = 2.29 years Unadjusted Rate of Return: a) =(-250000+98100+98100+98100+117100)/250000 = 161400 / 250000 = 64.56% b) = (-250000+125000+100000+87500+98900) / 250000 = 161400 / 250000 = 64.56%