Question

Heart Construction is analyzing its capital expenditure proposals for equipment in the coming year. The capital budget is limited to $15,000,000 for the year. Laura, staff analyst at Heart Construction, is preparing an analysis of the three projects under consideration by Mr. Heart, the company’s owner.

	Project A	Project B	Project C
Net initial investment	$6,600,000	$8,500,000	$9,000,000
Year 1 cash inflows	3,600,000	5,500,000	4,900,000
Year 2 cash inflows	3,600,000	2,000,000	4,900,000
Year 3 cash inflows	3,600,000	1,100,000	200,000
Year 4 cash inflows	3,600,000	0	100,000
Required rate of return	6%	6%	6%

Because the company’s cash is limited, Mr. Heart thinks the payback method should be used to choose between the capital budgeting projects.

Requirement

1. What are the benefits of the payback methods?
2. What are the limitations of the payback methods?
3. Calculate the payback period for each of the three projects. Ignore income taxes. Round your answer to 2 decimal places.
4. Based on the payback period, which project should Mr. Heart choose?
5. Calculate the simple rate of return for each project. Ignore income taxes.
6. Based on the simple rate of return, which project should Mr. Heart choose?

Answer 1

HI Frind,

Please see below solution for the question asked above: Thanks

Payback Period is the time where a project’s net cash inflows are equal to the project’s initial cash investment. This method is often used as the initial screen process and helps to determine the length of time required to recover the initial cash outlay (investment) in the project.

The main advantages of the payback period are as follows:

• A longer payback period indicates capital is tied up.
• Focus on early payback can enhance liquidity
• Investment risk can be assessed through the payback method
• Shorter-term forecasts
• This is a more reliable technique
• The calculation process is quicker than and simple than any other appraisal techniques
• This is a very easily understood concept

There are numbers of serious drawbacks to the payback Period Method:

• It ignores the timing of cash inflows within the payback period
• It ignores the cash flow produced after the end of the payback period and therefore the total return of the project.
• It ignores the time value of money
• Its influences for excessive investment in short term projects.
• (for the practical solution refer answer sheet attached)