Zaire Electronics Can Make Either of PDF [PDF]

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Question Zaire Electronics can make either of two investments at time 0. Assuming a required rate of return of 14 percent, determine for each project (a) the payback period, (b) the net present value, (c) the profitability index, and (d) the internal rate of return. Assume under MACRS the asset falls in the five-year property class and that the corporate tax rate is 34 percent. The initial investments required and yearly savings before depreciation and taxes are shown below:



Answer Step 1 Before doing large amount of investment and or capital expenditure, company evaluates all the available alternatives. Process of such evaluation of potential alternatives is termed as Capital Budgeting. Objective of such capital budgeting is to select the project proposal that increase the value of the firm. That means proposals whose present value of future cash inflows is more than the initial cash outlay is selected. Present value concept is based on time value of money which recognizes that $1 received today has more worth than the $1 received in some future date. ,



Step 2 Calculation of Cash Inflow from Project • Here, for savings from investment before depreciation and taxes are given. For capital budgeting techniques first we have to find out cash flow from both projects. • First from savings depreciation is to be deducted. Here, life of asset is given 5 years. And scrap value is assumed to be zero.



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• From Savings depreciation is to be deducted and on such amount tax @ 34% is to be calculated. • Now, as depreciation is noncash expense; it is added back to savings after tax to calculate net cash inflow from project. For Project A



For Project B:



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Step 3 a. Pay-back Period: • As an investor first question comes in the mind is that when will I get my money back? Pay-back period concept works on this ideology. • Pay-back period calculates the time period in which company will get its investment back in terms of future cash inflows. • Lower the pay-back period, better the project and vice-e-versa. • Payback period can be simply calculated by sequentially summing up all the future cash flows until cumulative value equals to initial investment.



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Calculation of Payback Period



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Step 4 b. Net Present Value: • Net present value means, present value of the benefits to be derived from the capital budget proposal. • If NPV of the project is positive, project is selected and if NPV of the project is negative, Project is rejected. • Net present value can be calculated as present value of the future cash inflows less present value of the future cash outflows less initial cash investment. ,



Step 5 Formula for Net Present Value: ,



Step 6



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Step 7 Calculation of NPV ,



Step 8



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Step 9 c. Profitability Index (PI): • It is one of the capital budgeting methods to evaluate the project proposals based on time value of money. • Present value of the future cash flows divided by the initial investment gives the profitability index of the project. • Profitability index is also known as benefit-cost ratio i.e. ratio of benefits cash flows received from the project as compared to investment / initial cash outlay. • If PI value is greater than 1, project should be accepted. If PI value is less than 1, project should be rejected. Formula for PI:



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Step 10 d. Internal Rate of Return: • Internal rate of return defines expected rate of return of the project. • In the other terms we can say that IRR is the rate at which present value of project’s all the cash flows is zero that means NPV of the project is zero. • If IRR of the project is more than the cost of capital i.e. r; then project should be accepted. • If IRR of the project is less than the cost of capital i.e. r; then project should be rejected. Formula to Calculate IRR



For Project A ,



Step 11



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Step 12 Calculation of IRR



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Step 13 For Project B ,



Step 14



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Step 15 Calculation of IRR



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Step 16 Among these four capital budgeting criteria; payback period does not consider time value of money while other three are based on time value of money concept.



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