A company is considering two alternative methods of producing a new product. The relevant data concerning the alternatives are presented below:
Initial investment $64,000 $120,000
Annual receipts $50,000 $60,000
Annual disbursements $20,000 $12,000
Annual depreciation $16,000 $20,000
Expected life 4 yrs 6 yrs
Salvage value 0 0
At the end of the useful life of whatever equipment is chosen the product will be discontinued. The company's tax rate is 50 percent and its cost of capital is 10 percent.
a. Calculate the net present value of each alternative.
b. Calculate the benefit cost ratio for each alternative.
c. Calculate the internal rate of return for each alternative.
d. If the company is not under capital rationing which alternative should be chosen? Why?
e. Again assuming no capital rationing, suppose the company plans to produce the product indefinitely rather than quit when the equipment wears out. Which alternative should the company select? Why?
f. If the company is experiencing severe capital rationing, and plans to terminate production when the equipment wears out, would any of your answers above change?
See attached file.
Note on Capital Budgeting
Capital budgeting involves making decisions about long term mix of the composition of assets of the business. As per Zen Wealth, "Capital Budgeting is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years. The decision to accept or ...
Solution explains benefit cost ratio for each alternative