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Q. No. 2 In evaluating the purchase of finishing equipment, ALCO Inc., estimates that two positions could be eliminated if the equipment was purchased. However,
Q. No. 2 In evaluating the purchase of finishing equipment, ALCO Inc., estimates that two positions could be eliminated if the equipment was purchased. However, additional inspection would be required for optimal operations. In current 20X0 annual prices, the wages and benefits of the two positions eliminated total TK.50,000 while the inspection amounts to Tk.8,000 annually. The equipment can be purchased and installed at a cost of Tk 75,000. The economic and tax life is 3 years. Depreciation is deducted for tax purposes as follows: Year 1, Tk 28,500; Year 2, Tk.27,750; and Year 3, Tk. 18,750. Management insists that a 5.4% rate for cost of capital be used. This rate does not include an allowance for inflation, which is expected to occur at an average annual rate of 10% over the next 3 years. The company adjusts for inflation rate to the cost of capital and then using the inflation- adjusted cost of capital to discount the projected cash flows. The company pays an average income tax rate of 46%. Assume all operating revenues and expenditures occur at the end of the year and would be subject to the effects of inflation Required (1) Analyze the expenditure under consideration using the company's method. (ii) Assume a consulting firm proposes a different adjustment for inflation in capital expenditure analyses, adjusting the cash flows by an estimated price level index. The adjusted after-tax cash flows are then discounted using the appropriate discount rate. The discount rate used is the cost of capital multiplied by the inflation rate. The estimated year-end index values for the next 4 years are as follows: Year Year-End Price Index 20X0 (current year) 1.00 20X1 1.10 20X2 1.16 20X3 1.20 Prepare a schedule, using the price index values provided showing the after-tax annual cash flows adjusted for inflation for the equipment under consideration. (iii) Determine the net present.value for the equipment using the method proposed by the consulting firm. (iv) Discuss the advice you would give management regarding the purchase. (v) Compare the consulting firm's approach to the one presently used to compensate for inflation
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