Decision by: NPV,IRR,Payback & After Tax Salvage Value

 - Before-

 Why is the NPV and IRR method a superior technique than the payback or ARR technique?

Both NPV and IRR use cash flows.

·   IRR – the number is internal or intrinsic to the project and does not depend on anything except the cash flows of the project.

·   IRR – in general is the rate that causes the NPV of the project to be zero.

NPV and IRR provide better decision.

· Accept a project if the NPV is greater than zero.

· Reject the project if NPV is less than zero.

· Accept the project if the IRR is greater than the discount rate (IRR>R).

· Reject the project if the IRR is less than the discount rate (IRR

- After -

 

If the NPV and IRR provide better decisions, why is the payback method a “popular” method?

Payback known as payback periods for making investment decision is simple, for example: a particular cut off sate, say two years, is selected. All investment projects that have payback periods of two years or less accepted and all of those that pay off in more than two years are rejected.

And payback method is often used when making relatively small decision, for example: manager might reason that a tune-up would cost $200, and if it saved $120 each year in reduced fuel cost, it would pay for itself in less than two years.

Why is the NPV method a better tool than the IRR method?

Because NPV has three attributes:

·   NPV uses cash flows – cash flows from a project can be used for other corporate purposes (such as dividend payments, other capital budgeting projects, or payments of corporate interest).

·   NPV uses all the cash flows of the project.

·   NPV discounts the cash flows properly.

Problem with IRR is when relate to Mutually Exclusive Project.

- After -

How do you find the after tax salvage value when the assets is not fully depreciated?

The after tax salvage value of the equipment – a cash inflow to the company. When selling an asset, one must pay taxes on the difference between the asset’s ales price and its book value. For example:

·Selling price at the end of year 5                       $30,000

·Book value at the end of the fifth year               $5,800

·Tax rate                                                          34%

·Tax liability                     34% ($30,000 - $5,800) = $8,228

·The after tax salvage value      $30,000 - $8,228 = $21,772 (cash inflow to company)

When assets is not fully depreciated, to find the after tax salvage value is still the same as above. The “accumulated depreciation” of assets must be find to get the book value of assets at the time assets sold, for example:

Book value of assets = Assets – Accumulated Depreciation of Assets

What is the Equivalent Annual Cost (EAC) and how do you use it?

EAC is an approach puts costs on a per year basis for each different machine. For example, a firm must choose between two machines of unequal lives. Both machines can do the same job, but they have different operating cost and will last for different time periods.

For example:

Machine                      0              1              2              3              4

A     : cash flows         $500       $120       $120       $120

A     : EAC                                      321.05   321.05   321.05

B     : cash flows         $600       $100       $100       $100       $100

B     : EAC                                      289.28   289.28   289.28   289.28

How to use it;

·  EAC can be used to compare cost between two machines; Would rather make lease payments of $321.05 or $281.28? a rational person would rather pay a lower amount. Thus machine B is preferred.

· EAC applies only for one anticipates that both machines can be replaced.

Reference:  Chapter 9, Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition.