ABC Inc. is evaluating a project that will increase annual sales by $230,000 and

ID: 1130721 • Letter: A

Question

ABC Inc. is evaluating a project that will increase annual sales by $230,000 and annual cash costs by $88,000. The project will initially require $145,000 in fixed assets that will be depreciated straight-line to a zero book value over the 4-year life of the project. The applicable tax rate is 35 percent.

A. What is the operating cash flow for this project?

ABC Inc. has determined that it requires $35,000 in NWC, has a required rate of return of 14%, and requires all projects to pay back within 4 years. (Hint: Include NWC at the beginning and end of project)

B. What is the payback period? Using the decision rule, should we accept the project?

C. What is the discounted payback period? Using the decision rule, should we accept the project?

D. What is the IRR? Using the decision rule, should we accept the project?

E. What is the NPV? Using the decision rule, should we accept the project?

Explanation / Answer

Question A). Solution :- Calculation of operating cash flow (OCF) for the project :-

Sales

(-) Cost

230000

88000

Earning before depreciation and tax

(-) Depreciation (145000 / 4)

142000

36250

Earning before tax

(-) Tax expense (35 % of 105750)

105750.00

37012.50

Net income

(+) Depreciation

68737.50

36250.00

Conclusion :- Operating cash flow for the project = $ 104987.50

Question B). Solution :- Calculation of payback period of project :-

Present value of cash outflow = 145000 + 35000 = $ 180000.

Payback period of project lies between Year 1 and Year 2, Accordingly, by inter-polation, Payback period is calculated as follows :-

= 1 + (180000 - 104987.50) / 104987.50

= 1 + 75012.50 / 104987.50

= 1 + 0.71

= 1.71 Years.

Conclusion :- Payback period of project = 1.71 Years. (The project should be accepted because the payback period of project is less than the pre-determined target period of 4 years mentioned in the question.)

Question C). Solution :- Calculation of the discounted payback period of project :-

Present value of cash outflow = 145000 + 35000 = $ 180000.

Discounted Payback period of project lies between Year 2 and Year 3, Accordingly, by inter-polation, discounted Payback period is calculated as follows :-

= 2 + (180000 - 172809.43) / 70866.56

= 2 + 7190.57 / 70866.56

= 2 + 0.10

= 2.10 Years.

Conclusion :- Discounted Payback period of project = 2.10 Years. (The project should be accepted because the discounted payback period of project is less than the pre-determined target period of 4 year mentioned in the question.)

Question E). Solution :-

Net present value (NPV) = Present value of cash inflow - Present value of cash outflow.

= 326548.59 - 180000

= $ 146548.59

Conclusion :- Net present value (NPV) of Project = $ 146548.59 (The project should be accepted because the net present value (NPV) of project is positive).

Particulars Amount ($)