Reference no: EM132567269

Senior Management at Pennants Distributors Limited is currently considering whether to invest in one of two machines: Vinnie and Cam. Both machines have a useful life of four years and are to be depreciated using the straight line basis. The cost, insurance and freight (CIF) of the Vinnie is Jamaican equivalent $20,000,000. The custom duty on the asset is J$5,000,000. The asset is to be depreciated to a residual value of $1,000,000. The Vinnie is to be bought in Miami, Florida. Meanwhile, the CIF of the Cam is Jamaican equivalent $24,000,000 and can be depreciated to a residual value of $2,000,000. The Cam is sold by a supplier in New York. The custom duties on the asset is J$6,000,000. The useful lives of the machines are the same as the project. However, the machines are mutually exclusive. The assets expect to increase efficiency by reducing annual operating costs.

The annually savings from each machine were analyzed by the production manager and provided in a report to senior management below:

Year Vinnie Cam

1 $10,000,000 $16,000,000

2 $16,500,000 $16,000,000

3 $18,000,000 $16,000,000

4 $17,000,000 $12,000,000

The entity's projects are discounted using the weighted average cost of capital. The company's marginal tax rate is 40% and depreciation is an allowable deduction for income tax purposes. It is assumed that all cash inflows occur at the end of each year. Projects are to be financed with 50% debt. The cost of debt is 12%. On the other hand, the cost of equity is determined using the capital asset pricing model. The risk free rate is half the cost of debt and the average return on the market is 16%. The stock's beta is 1.50.

Required:

Question a. Compute and explain briefly, the term cost of capital

Question b. Compute the following for each of the machines above

i. Net present value

ii. Accounting rate of return using initial investment

iii. Internal rate of return