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AFM 471 Chapter Notes -Sunk Costs, Real Interest Rate, Nominal Interest Rate

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School
University of Waterloo
Department
Accounting & Financial Management
Course
AFM 471
Professor
Tu

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Document Summary

Another application of npv analysis - investments of unequal lives. When comparing mutually exclusive alternatives, npv does not always give the correct answer as to which is better if the alternatives are of different lengths. For example, if one was comparing two brands of the same machine where brand a costs more but lasts longer than brand b. Npv does not take different lifespans of projects into account and biases against taking short-life alternatives. Example: machine a costs ,000 and increases profits by per year. The machine lasts for six years (at which time it breaks down and is no longer usable). and increases profits by per year. This machine is expected to last for 3 years. Simply choosing the highest npv means to choose machine a. If this is a one-shot deal, this is correct. That is, if you will only buy a machine once.

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Related Questions

SingTel Ltd. is an Australian operated company with mainly Singaporean resident shareholders. The company is currently in the process of comparing two mutually exclusive machines for use in a new project with Machine A costing $30,000, having a useful life of five years and machine B costing $45,000 and having a useful life of 10 years. Cash inflows from sales are expected to be $22,000 p.a. from each machine, while total cashbased operating costs are expected to be $10,000 and $8,000 respectively for each machine. All revenues and costs are assumed to occur at the end of the respective years for simplicity of assessment. Machine A is expected to have a salvage value of $4,000 at the end of 5 years, while at the end of 10 years machine B will be worthless. Depreciation for accounting and tax purposes is calculated on a straight-line basis on the original cost of each machine with no consideration in depreciation calculations for any expected salvage value. The company has an aftertax required rate of return of 14% and pays income tax at the rate of 40% in the year following the year of income (that is, taxes levied on year 1 income are paid at the end of year 2). a) Provide some reasons as to why the alternative machines are said to be mutually exclusive for the company. b) Record the relevant cash-flows for each machine on a time (cash-flow) diagram. c) Advise the company which machine (if any), should be purchased and justify all the processes you have used in order to reach your decision. d) (i) Why is NPV considered to be the best method for capital budgeting? What does the NPV tell you? (ii) When evaluating two mutually exclusive projects with unequal lives, is the project with the higher NPV better? Why or why not?