XYZ Limited is considering two projects. Each requires an immediate cash outlay: $10,000 for A, $9,000 for B. Project A has a life of four years, project B five years; neither will have any salvage value at the end of its life. For tax purposes, each would be depreciated by the straight-line method, project A at 30 percent, project B at 24 percent. The company’s tax rate is 40 percent, and its required rate of return after tax is 11 percent. Net cash flows before taxes have been projected as follows.
Year 1 2 3 4 5
Project A 3200 3200 4000 4100
Project B 4000 4000 1900 1800 1800
a) Calculate the net cash flows after tax for each project. (Assume that XYZ Limited has a substantial taxable income so that, where a project has a negative taxable income in a particular year, this will give rise to a tax saving by the firm.)
b) Compute the payback for each investment.
c) Compute the average rate of return for each investment.
d) Compute the net present value for each investment.
e) Should XYZ Limited adopt project A, project B, both, or neither? Why?