ABC Corp. concluded a market research study on a 4-yr project. The Project’s expected NPV is $55,000, its equivalent annual cost is 18,000 and depreciation is 3,000 per year. If the firm pays taxes at 40%, then its required rate of return is closest to A) 11.7% B) 13.5% C) 17.8% D) 19.4%
A? PV = 55 * .6 N=4 PMT = -18 * .6 CPT I/Y = 11.716
A cf0=55 cf1=-18 f1=4 irr=11.71
CF0 = -55 C01 = 21 FO1 = 4 CPT–> IRR = 19.38813 = D? - Dinesh S
A is the correct answer, but why didn’t we take the tax advantage of depreciation. My calculations were as follows (18,000 + 3,000)*.6 = 12,600 add back depreciation (3,000) = 15,600 n=4 pv=-55,000 pmt=15,600 i --> 5.25% (which obviously is incorrect) Thanks…
We add back depreciation when we are calculating the after tax cashflows. Since we are concerned with the NPV of the investment, we isregard it
yeah, I guess I got confused with the alternative investment: RE, after tax CF valuation approach…spent like 5 mins on this question, got it wrong… and was so pissed for the rest of the exam. also this was like que 79 in PM session, by that time, I am in such a foul mood.
That’s what I did too delhirocks.
I wanted to add depreciation in there too. but then i thought that only cash flows should be included.
A. I think for NPV you would ignore depn bcos its not a “real” cash flow. n = 4 PV = 55000 pmt = 18000 I/Y = 11.71% For a moment i was wondering how in the world do you reverse engineer a NPV calculation… =p
equivalent annual cost. where is this concept defined? Is this optional material?
^ I thought that too…wrote a nice equation…and then scrapped it.
Looks like i got the correct option inspite of my best efforts to sabotage myself. The only reason i did not use the depreciation was that because I interpreted it as the depreciation of the project costs over the life of the project’s benefits . and factoring that into the costs would kind of be double counting.
I guess the easiest way to look at this is: Cash flows from Asset= return on asset + return of asset = income + depreciation Therefore the cash flow incorporates the depreciation
So I guess the concept behind this question is IRR = Discount rate that makes the NPV = 0. We know the 4 annual CF of 18,000 + some initial investment discounted at an unknown rate will give an NPV = 55,000. To get an NPV =0, we would take -55K as CF0, input the CF and calculate for IRR. Am I correct in interpreting the question/concept?
Yes I’m a bit confused as to why 4 OUTFLOWS would yield a positive NPV…the underlying calculation would make sense to me if those were inflows rather than outflows…