Zaire Electronics Can Make Either of PDF

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:
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.
Calculation of Payback Period
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
Step 7
Calculation of NPV
,
Step 8
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:
,
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
Step 12
Calculation of IRR
Step 13
For Project B
,
Step 14
Step 15
Calculation of IRR
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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