Corporate Finance Case of Computation of NPV - Essay Example

Running Head: CORPORATE FINANCE CASE Corporate Finance Case in APA Style by SUMMARY OF ANSWERS QUESTION 1. a. NPV = $17,127 b. Decision: Accept Project QUESTION 2. a. Payback Period = 3.36 years b. Decision is to accept project since payback period is less than 6 years. c. Discounted Payback = 5.43 years QUESTION 3. Theoretical weaknesses of payback period includes: (1) its incapacity to include the time-value of money by giving each dollar the same weight and (2) its non-consideration of cash flow beyond payback period. QUESTION 4. a. IRR = 24.7%; Decision: Accept Project b. In Excel, formula is IRR (expected future cash flows from Year 0 to Year 8). c. MIRR = 19.9%; Decision: Accept Project d. MIRR is less than IRR since it eliminates multiple IRR resulting from the assumption that each cash flow is invested at the company's cost of capital instead of the project's own IRR. QUESTION5. a. NPV: $18,436; IRR: 25.6%; b. Decision: Accept Project since NPV is positive and IRR is greater than required rate of return c. Positive NPV indicates that the company will be generating higher cash inflow than its cost of capital QUESTION 6. a. NPV and IRR decline while payback period is longer b. Decline is due to the decrease in tax shield from depreciation during the earlier years where the value of dollar is greater than the succeeding years QUESTION 7. a. NPV increase to $23,126 because of the decrease in initial capital outlay QUESTION 8. a. CF0 increase, CFt decrease, TCFn decrease b. NPV = $9, 878; IRR = 21.4%; Decision: Accept Project QUESTION 9. a. NPV = -$248; Decision: Reject project b. IRR = 15.9; Decision: Reject project QUESTION 1 1. The computation of NPV for the project starts with the projection of cash flows. Initial investment is computed by adding up the cost of acquisition of the equipment less the market value of the old machine net of taxes. The yearly cash flows are computed by adding the incremental savings less the tax shield from depreciation. At the end of the eight year, it is assumed that the company sell the machine at $20,000. Thus, this value net of taxes is added on the eight year cash flow. Lastly, the cash flows are discounted using 16% cost of capital and are added up to come up with the NPV. a. Computed NPV for the project is $17,127. In this case, NPV is calculated through Excel by the formula: Initial capital outlay + NPV (16%, yearly cash inflow). b. This positive NPV implies that the project yields cash flows which are greater than the required rate of return. Thus, the investment decision is to accept the project. 2. The payback period for a project can be computed by subtracting the initial capital outlay with the expected yearly cash flow. a. The calculated payback period for the project is 3.36 years. b. Since the decision criterion of the company is to accept projects whose payback periods are within six years, this project is viewed to have a good profit potential. Investment decision is to accept the project. c. Different from the simple payback period, the discounted payback requires the cash flows to be discounted. Thus, it is expected that the discounted payback period is longer than the simple one. In this case, the discounted payback is 5.43 years. 3. Two of the conceptual weaknesses of the payback period are the following: inability to recognize the time-value of money by treating each dollar inflow as the same whether they are generated earlier or later in the projects life and its lack of recognition for the cash inflows after the initial investment is recouped. These flaws of the payback period make it inferior to other capital budgeting techniques. For example, because it does not discount cash flow, it is not realistic to use since we know that the value of money depreciates over time. Also, it becomes misleading when assessing projects which have lower cash flows in the early project life and large ones in its later years. The payback period almost always favor projects where the investment can be recouped at a shorter time. 4. The internal rate of return is computed as the interest rate which equates NPV to zero. a. The computed IRR for this project is 24.7%. Since the decision criterion for IRR is to pursue projects where it is greater than the cost of capital, the computed IRR is compared with the 16% required rate of return that the company preset. Thus, the project in this case is accepted. b. In Excel IRR is calculated as: IRR (expected cash inflow from year 0 to year 8). c. MIRR computed is 19.9%. Since MIRR is still greater than the required rate of return, the project is accepted. d. The MIRR of any project is always less than the IRR. The difference of MIRR and IRR can be explained by the use of the company's required rate of return in the computation of MIRR in contrast to the usage of the projects' rate of return in IRR. In this case, the MIRR's reinvestment rate is 16% while IRR's is 24.7%. 5. If the project is discounted in five year instead of the original eight year period, it is expected that depreciation is higher in five years. Thus, the cash flows from years 1-5 are also greater because of the higher tax shield from depreciation. a. The computed NPV for the project with the five year depreciation equals $18,436. Meanwhile, IRR is computed to be 25.6%. These results are consistent with the above expectation that projects will have higher cash flows during the first five years. b. Since NPV is positive and IRR is greater than the 16% required rate of return, the project is accepted. c. The positive NPV is an indication that the project generates higher cash flow than the company's required rate of return. 6. Straight line depreciation involves depreciating the value of the equipment equally for eight years. a. & b. Compared to MARCS, straight line depreciation brings equal stream of cash flow from years 1-5. In MARCS, depreciation is greater early at the project's life leading to higher tax shield of depreciation. Since NPV favors higher cash flow at earlier years, NPV is expected to decline with the use of straight line depreciation. It also follows that IRR is also lower. Payback period is also expected to become longer. 7. With the investment tax credit of 10%, it is expected that the initial cash outlay will be less by the $6,000. However, future cash inflows will remain the same. With this reduction in initial cash outlay, it is expected that NPV will increase. When computed with the 10% investment tax credit, NPV rises to $23,127 which is $6,000 greater than the case without the ITC. 8. a. The increase in taxes will have a direct impact in cash flows in initial investment and yearly cash inflows. Since the increase in tax rate will make the tax payable for the sale of the old market, initial outlay is expected to increase. In this case, it will go up from $56,700 to $57,000. Total cash inflows will also decline as yearly cash inflow will decrease in response to the higher level of taxes collected. b. Computed NPV at a tax rate of 40% is lower at $9,788 while IRR is 21.4%/ Even though both of these measures are lower, NPV is still positive and IRR is still greater than 16% making the project still acceptable. 9. a. The NPV computed is -$248 which is due to the increase in initial investment. Since NPV is negative, it implies that it does not satisfy the required rate of return set by the company. In this situation, the project is rejected. b. The computed IRR for the project is 15.9%. It should be noted that the IRR is less than the required rate of return of 16% and is consistent with the negative NPV computed above. Thus, decision is to reject the project. Read More