Annual Income 30000 20000 10000 Average annual income 3000020000100003 20000

Annual income 30000 20000 10000 average annual income

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Annual Income 30000 20000 10000 Average annual income = (30000+20000+10000)/3 = 20000 Average net book value if the investment = (100000+0)/2 = 50000 Accounting rate of return = 20000/50000 * 100 = 40% The firm will accept the project if its target rate is less than 40%.
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Financial Management 82 Ques 21 A ltd is considering the purchase of a new leather cutting machine to replace an existing machine which has a book value of Rs. 3000 and can be sold for Rs. 1500. The estimated salvage value of the old machine in four years would be zero, and it is depreciated on a straight line basis. The new machine will reduce costs (before tax) by Rs. 7000 per year i.e. Rs. 7000 cost savings over the old machine. The new machine has a four year life, costs Rs. 14000 and can be sold for an expected amount of Rs. 2000 at the end of the fourth year. Assuming straight line depreciation and a tax rate of 40%, calculate the cash flows associated with the investment and calculate the NPV of the project assuming the cost of funds to the firm is 12% and straight line method is used for tax purposes? Ans. Cash flows associated with the replacement decisions Year 0 1 2 3 4 1. Net investment in new machine (12500) 2. Savings in costs 7000 7000 7000 7000 3. Incremental Depreciation 2250 2250 2250 2250 4. Pre-Tax profits 4750 4750 4750 4750 5. Less Tax 1900 1900 1900 1900 6. Post-tax profits 2850 2850 2850 2850 7. Initial Flow (=1) (12500) 8. Operating Flow (= (6) + (3)) 5100 5100 5100 5100 9. Terminal Flow 2000 10. Net Cash flow(=7+8+9) 12500 5100 5100 5100 7100 Year 1 2 3 4 Net cash flows 5100 5100 5100 7100
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Financial Management 83 PVIF @k = 12% 0.893 0.797 0.712 0.636 Present Value (Rs.) 4554 4065 3631 4516 Net present value = (-12500) + (4554 + 4065 + 3631 + 4516) = Rs. (-12500 + 16766) = Rs. 4266 The decision rule based on NPV is obvious. A project will be accepted if the NPV is positive and rejected if NPV is negative. Ques 22. Project has the following patterns of cash flows: Year Cash Flow (Rs. In Lakh) 0 (10) 1 5 2 5 3 3.08 4 1.20 What is the IRR of this project? Ans.: To determine the IRR, we have to compare the NPV of the project for different rates of interest until we find that rate of interest at which the NPV of the project is equal to zero. To reduce the number of iterations involved in this hit and trial process, we can use the following short cut procedure: Step 1 Find the average annual net cash flow based on given future net cash inflows.
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Financial Management 84 = (5 + 5 + 3.08 + 1.20)/4 = 3.57 Step 2 Divide the initial outlay by the average annual net cash inflows i.e. 10/3.57 = 2.801 Step 3 From the PVIFA table find that interest rate at which the present value of an annuity of Rs. 1 will be nearly equal to 2.801 in 4 years i.e. the duration of the project. In this case the rate of interest will be equal to 15%. We use 15% as the initial value for starting the hit and trial process and keep trying at successively higher rates of interest until we get an interest rate at which the NPV is zero. The NPV at r = 15% will be equal to: = - 10 + (5 * .0870) + ( 5 * .756 ) + (3.08 * .658 ) + ( 1.2 * .572) = 0.84 NPV at r = 16 % will be equal to: = - 10 + (5 * .862) + (5 * .743) + (3.08 * .641) + (1.2 * .552) = .66 NPV at r = 18% will be equal to: = - 10 + (5 * .848) + (5 * .719) + (3.08 * .0609) + (1.2 * .516) = .33 NPV at r = 20% will be equal to: = -10 + (5 * .833) + (5 * .694) + (3.08 * .609) + (1.20 * .482) = 0 We find that at r= 20%, the NPV is zero and therefore the IRR of the project is 20%.
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