Question

Capital Budgeting Decision Rules:
1. Payback period approach in capital budgeting evaluation process fails to consider all cash flows and the time value of money.
True False

2. If a project’s NPV is positive, then it is IRR is greater than its cost of capital.
True False
A project will cost $160,000. The after-tax future cash flows are expected to be $40,000 annually for 7 years. For #3-5.

3. What is the project’s payback period?
A. 1.5 yrs B. 2.0 yrs C. 3.3 yrs D. 4.0 years E. 4.3 years

4. Assume the required return is 10%. What is the project’s NPV?
A. $14,111 B. $27,322 C. $32,556 D. $34,737 E. $45,001

5. Assume the required return is 17%. What is the project’s IRR? Accept?
A. 12.2%; yes
B. 12.2%; no
C. 16.3%; yes
D. 16.3%; no
E. 17.0%; indifferent

6. XYZ company is planning to buy the ABC company. The acquisition would require an initial investment of $190,000, but in one year XYZ company's after-tax net cash flows would increase by $24,000 and remain at this new level annually forever. Assume a cost of capital of 10 percent. Should XYZ buy ABC?

Please provide all work for these problems not just final solutions so they can be modeled for other similar problems. Thank you :)

Answer 1

1. True. Payback period measures the time required to recover the initial outlay and it does not consider the cash flows after recovering of initial outlay. It is the drawback of payback period that it does not consider time value of money. Therefore the given statement is true that payback period approach in capital budgeting evaluation process fails to consider all cash flows and the time value of money.

2. True. If NPV is positive then its IRR is greater than cost of capital

Lets take an example, if projects cost is $2000, cash inflows for next three years will be $1000 a year. cost of capital is 10%

Its NPV will be 486.85 and its IRR will be 23%, which is more than cost of capital.

Hence the given statement is true.

3. Payback Period

Period	Cash Flow	Cumulative cash flow
0	-160000	-160000
1	40000	-120000
2	40000	-80000
3	40000	-40000
4	40000	0
5	40000	40000
6	40000	80000
7	40000	120000

Since at year 4 the cumilative cash flow is zero, it means it take 4 years to recover its initial outlay. Thus, Payback period is 4 years. Option D. 4 years is correct

4. NPV

Period	Cash Flows	PV factor @10%	PV of cash flows
1	40000	0.909	36363.636
2	40000	0.826	33057.851
3	40000	0.751	30052.592
4	40000	0.683	27320.538
5	40000	0.621	24836.853
6	40000	0.564	22578.957
7	40000	0.513	20526.325
		Total	194736.753

Present value of future cash inflows = 194736.753

Present value of cash outflow = 160000

NPV = Present value of future cash inflows - Present value of cash outflow

NPV = 194736.753 - 160000

= 34736.753

So NPV of the project is $34736.753 after rounding off it will be $34737. Correct answer is Option D. 34,737