The net initial investment is calculated by subtracting all cash inflows occurring at time zero from all cash outflows occurring at time zero.
The following table provides a general format for computing net initial investment:
Format for Determining Net Initial Investment Project cost or cost of new fixed assets XXX Add: Cost of installation, insurance, transport XX Add: Positive net working capital XX Deduct Cash inflows from the proceeds of old fixed asset disposal XX A(D) Taxes (tax savings) on old asset disposal XX Net Initial investment (or net initial cash outflows) XXX
Let us assume that the Lalibela Corporation wants to introduce new production machinery. The cost of the needed machinery is Br. 1,000,000. The machinery is expected to last for 4 years, after which time it will have a scrap value of Br. 8,000. The corporation spends Br. 19,000 in transporting the machinery from the manufacturer and in installing the machinery in its plant .
The net initial investment is Br. 1,019,000. This is the sum of the cost of the machinery and the transportation and installation expenses (Br. 1000,000 + Br. 19,000). Scrap value of the new machinery and financing arrangements are not included in the computation.
The rules that determine the tax impact of selling a depreciable asset are summarized below:
1. If an asset is sold for less than its book value, the company realizes a decrease in its tax liability equal to 40 percent (assume) of the difference between the selling price and the book value of the asset.
2.If the asset is sold for its book value, there is no impact on corporate taxes.
If the asset is sold for more than its BV but for an amount equal to or less than its original cost, the corporation incurs an increase in its tax liability equal to 40 % of the difference between the selling price and the BV of the asset.
Assume a new line of machinery is purchased to replace existing machinery by XYZ Corporation. The new machinery costs including installation cost amounts Br.2,500,000 and an expected salvage value of Br.250, 000 after ten years. The existing machinery originally cost Br. 800,000 and has a current book value of Br. 100,000.Based on the following independent assumptions with regard to old machinery disposal value, compute NII of the project.
Computation of Payback period. When an investment’s cash flows are in annuity form , payback period can be computed by dividing the value of net annual cash inflow into the project’s net initial investment.
An investment alternative has a net initial investment of Br. 100,000 and produces a cash inflow annuity of Br. 14,000 for 16 years. Compute the NPV of the investment if the required rate of return (cost of capital) for the investment is 10 percent. Would you recommend accept or reject this project?
IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. Or It is defined as the discount rate that produces a zero NPV.
In the discussion of the NPV criterion (example 1), a project that required a NII of Br. 100,000 produced 16 annual cash flows of Br. 14,000 each. It required a 10 % rate of return, and had an NPV of Br. 9,536.
Since the NPV is positive at a discount rate of 10 %, the project’s actual rate of return exceeds 10%. Dividing the NII by the value of one net cash inflow and, then, locating the resulting quotient in the present value annuity table, helps to obtain the IRR for this project.
Chances are that the IRR based on the Br. 20,000 annuity will provide a better first guess because it is based on the cash flows that occur in the earliest years of the original project. An alternative is to take the arithmetic average of the IRRs of the two annuities as follows: