QUESTION 1
This question relates to alternative investment choice techniques
Andrew Hardcastleis considering the following cash flows for two mutually exclusive projects.
Year Cash Flows, Investment M ($) Cash Flows, Investment N ($)
0-48,000 -48,000
1 15,000 24,000
2 24,000 24,000
3 36,000 24,000
You are required to answer the following questions:
i) If the cash flows after year 0 occur evenly over each year, what is the payback period for each project, and on this basis, which project would you prefer?
IN THE REMAINING PARTS, ASSUME THAT ALL CASH FLOWS OCCUR AT THE END OF EACH YEAR.
ii) Would the payback periods then be any different to your answer in i)? If so, what would the payback periods be?
iii) If the required return is 10% per annum, what are:
- the net present valuesof each project?
- the present value (or profitability) indexes of each project?
iv) Calculate the internal rate of return (IRR) for each project.
[NOTE: It is satisfactory if the approximate IRR is calculated for Investment X by trial and error, and stated as a percentage correct to the nearer whole number. The IRR for Investment Y should be calculated as a percentage exactly, correct to 1 decimal place.]
v) Calculate the exact crossover point(an interest rate, expressed as a percentage correct to two places of decimals) of the respective net present values for the above projects.
vi) Having regard to the above calculations, state - with reasons - which of investments M and N you would prefer.
QUESTION 2
This question relates to capital budgeting.
Interstate Haulage Ltdis considering the purchase of two new modern large truckscosting $500,000 each, which it will fully financewith a fixed interest loan of 8% per annum, with interest paid monthly and the principal repaid at the end of 4 years. The trucks will be used in the company's interstate and intra-state trucking business.
The two new trucks will replace three existing smaller trucks and will permit the company to reduce its storage costs by $50,000 a year and its labour costs by $200,000 a year, both over the next 4 years. [Assume these savings are realized at the end of each year.]
The new trucksmay be depreciated for tax purposes by the straight-line method to zero over the next 4 years. The company thinks that it can sell the trucksat the end of 4 years for $150,000 each.
The three smaller old trucks were bought 1 year ago for $250,000 each, with a then life expectancy of 5 years, and have been depreciated by the straight-line method at 20% a year. If the company proceeds with the above purchase, the old trucks will be sold this month for $100,000 each.
This is not the first time that the company has considered this purchase and replacement. Twelve monthsago, the company engaged Cartage Consultants, at a fee of $20,000 paid in advance, to conduct a feasibility study on savings strategies and Cartagemade the above recommendations. At the time, Interstate Haulage Ltd did not proceed with the recommended strategy, but is now reconsidering the proposal.
Interstate Haulage Ltdfurther estimates that it will have to spend tax-deductible amounts of $40,000 in 2 years' time and $50,000 in 3 years' time overhauling the trucks.
It will also require additions to current assets of $30,000 at the beginning of the project, which will be fully recoverable at the end of the fourth year.
Interstate Haulage Ltd'scost of capital is 10%. The tax rate is 30%. Tax is paid in the year in which earnings are received.
REQUIRED:
(a) Calculate the net present value (NPV), that is, the net benefit or net loss in present value terms of the proposed purchase costs and the resultant incremental cash flows.
[HINT: As shown in the text-book, it is recommended that for each year you calculate the tax effect first, then identify the cash flows, then calculate the overall net present value. Finally, make your recommendation.]
(b) Should the company purchase the new trucks? State clearly why or why not.