Question

It has been proposed that a company invest $1 million of its own funds in a venture which will yield a gross income of $1 million per year. The total annual costs will be $800,000 per year. In an alternative proposal, the company can invest a total of $600,000 and receive annual net earnings of $220,000 from the project. The remaining $400,000 can be loaned at an effective 6% annual interest rate. Calculate the cash flows of each option and determine the more profitable alternative for the company with regards to investing its available funds. Assume a constant depreciation rate of 20% per year and an income tax rate of 35%.

Answer 1

Answer:

Alternative 1: $144,000

Alternative 2: $158,400

Alternative 2 is more profitable.

Explanation:

Given that,

Depreciation = 20% per year

Tax rate = 35%

Effective annual interest rate = 6%

For Alternative 1:

Investment cost = $800,000 per year

Gross income = $1,000,000

Profit before tax:

= Gross income - Investment cost

= $1,000,000 - $800,000

= $200,000

Taxable profit = Profit before tax - Depreciation

                       = $200,000 - (0.2 × $200,000)

                       = $200,000 - $40,000

                       = $160,000

Profit after tax = Taxable profit (1 - Tax rate)

                        = $160,000(1 - 0.35)

                        = $104,000

Cash flow = Profit after tax + Depreciation

                 = $104,000 + $40,000

                 = $144,000

For alternative 2:

Total Investment = $600,000

Annual net earnings = $220,000

Amount loaned = $400,000

Taxable profit = Profit before tax - Depreciation

                       = $220,000 - (0.2 × $220,000)

                       = $220,000 - $44,000

                       = $176,000

Profit after tax = Taxable profit (1 - Tax rate)

                        = $176,000(1 - 0.35)

                        = $114,400

Cash flow = Profit after tax + Depreciation

                 = $114,400 + $44,000

                 = $158,400

Hence, on the basis of Cash flow, the second alternative will provide more profits.