E0700237.FIN

E0700237.FIN - E07700237 Question 1 Year Initial 1 2 3 4...

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E07700237 Question 1 Year WB($) SS($) Initial -600,000 -600,000 1 30,000 300,000 2 200,000 300,000 3 300,000 200,000 4 500,000 100,000 i. On project WB, after 3 years the firm will have recaptured $ 530,000 on an initial investment of $600,000, leaving $70,000 of the initial investment still be recouped. During the fourth year, a total of $500,000 will be returned from this investment. Assuming cash will flow into the firm at a constant rate over the year. Thus, the payback period on project WB is (3+ 70,000/ 500,000) = 3.14 years On project SS, after 2 years the firm will have recaptured $ 600,000 on an initial investment of $600,000. Thus, the payback period on project SS is 2 years. The payback period of project SS is shorter than project WB, so time to recapture initial investment is shorter. Therefore, project SS should be chosen. ii. Suppose there is no corporate tax and the cash flows above are income before the depreciation and the firm uses a straight-line depreciation method to zero. 1
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E07700237 Depreciation = $600,000 Accounting rate of return (AROR) AROR = 1 1 2 n t AP n IO SV = + Where AP t = accounting profit in year t IO = the initial outlay SV = the expectation salvage value of the project n = the expected life of the project Accounting profit of WB = (30,000 + 200,000 + 300,000 + 500,000) – 600,000 = $430,000 Accounting profit of SS = (300,000 + 300,000 + 200,000 + 100,000) – 600,000 = $300,000 Thus, 430,000/4 AROR WB = = 0.3583 = 35.83% 600,000/2 300,000/4 AROR SS = = 0.25 = 25% 600,000/2 AROR of WB project is higher than SS project (35% > 25%). Thus, profit return form investment of WB project is higher SS project. Therefore, WB project should be chosen. iii. 2
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E07700237 WB project 600,000 = 1 30,000 (1 ) WB IRR + + 2 200,000 (1 ) WB IRR + + 3 300,000 (1 ) WB IRR + 4 500,000 (1 ) WB IRR + Try IRR WB = 18% = 0.18 1 30,000 (1 18%) + + 2 200,000 (1 18%) + + 3 300,000 (1 18%) + 4 500,000 (1 18%) + =$609,544 Try IRR WB = 19% = 0.19 1 30,000 (1 19%) + + 2 200,000 (1 19%) + + 3 300,000 (1 19%) + 4 500,000 (1 19%) + =$593,802 IRR WB = 18%+ 609,544 600,000 609,544 593,802 - - =18.61%>15% SS project 600,000 = 1 300,000 (1 ) SS IRR + + 2 300,000 (1 ) SS IRR + + 3 200,000 (1 ) SS IRR + + 4 100,000 (1 ) SS IRR + Try IRR SS = 22% = 0.22 1 300,000 (1 22%) + + 2 300,000 (1 22%) + + 3 200,000 (1 22%) + 4 100,000 (1 22%) + =$602,742 Try IRR SS = 23% = 0.23 1 300,000 (1 23%) + + 2 300,000 (1 23%) + + 3 200,000 (1 23%) + 4 100,000 (1 23%) + =$593,364 3
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E07700237 IRR SS =22%+ 602,742 600,000 602,742 593,364 - - =22.29%>15% WB and SS projects can be accepted because the IRR is higher than the required rate of return of 15%. But the IRR of SS project is greater than IRR of WB project. It means the return from investment on SS project is greater than IRR of WB. So, SS project should be chosen. iv
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This note was uploaded on 07/30/2011 for the course FIN 202 taught by Professor Hung during the Spring '11 term at Keuka.

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E0700237.FIN - E07700237 Question 1 Year Initial 1 2 3 4...

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