Question

Clarabelles Construction is analyzing its capital expenditure proposals for the purchase of equipment in the coming year. The capital budget is limited to $ 12 comma 000 comma 000 for the year. Lenora Bentley​, staff analyst at Clarabelles​, is preparing an analysis of the three projects under consideration by Calvin Clarabelles​, the​ company's owner. LOADING... ​(Click the icon to view the data for the three​ projects.) Present Value of $1 table LOADING...    Present Value of Annuity of $1 table LOADING...    Future Value of $1 table LOADING...    Future Value of Annuity of $1 table LOADING... Read the requirements LOADING.... Requirement 1. Because the​ company's cash is​ limited, Clarabelles thinks the payback method should be used to choose between the capital budgeting projects. a. What are the benefits and limitations of using the payback method to choose between​ projects? Benefits of the payback​ method: A. Easy to understand and captures uncertainty about expected cash flows in later years of a project Your answer is correct.B. Indicates whether or not the project will earn the​ company's minimum required rate of return C. Utilizes the time value of money and computes each​ project's unique rate of return D. All of the above Limitations of the payback​ method: A. Fails to incorporate the time value of money and does not consider a​ project's cash flows after the payback period This is the correct answer.B. Cannot be used when​ management's required rate of return varies from one period to the next. C. Cannot be used for projects with unequal periodic cash flows Your answer is not correct.D. All of the above b. Calculate the payback period for each of the three projects. Ignore income taxes. ​(Round your answers to two decimal​ places.) Project A 2.93 years Project B 2.86 years Project C 1.7 years Using the payback​ method, which​ project(s) should Clarabelles ​choose? Projects B and C Requirement 2. Calculate the NPV for each project. Ignore income taxes. ​(Round your answers to the nearest whole dollar. Use parentheses or a minus sign for negative net present​ values.) The NPV of Project A is $ . Enter any number in the edit fields and then click Check Answer. Project A Project B Project C Projected cash outflow Net initial investment $6,000,000 $4,000,000 $8,000,000 Projected cash inflows Year 1 $2,050,000 $1,100,000 $4,700,000 Year 2 2,050,000 2,300,000 4,700,000 Year 3 2,050,000 700,000 50,000 Year 4 2,050,000 25,000 Required rate of return 8% 8% 8%

Answer 1

1. a. Benefits of payback method:

The correct answer is Option a - Easy to understand and captures uncertainty about expected cash flows in the later years of project.

The payback method does not consider time value of money. Also, this method helps the company in analysing the number of years it takes for the company to recover its initial investment. Hence, it won't give any information about whether the company can earn minimum required rate of return or not.

Limitations of payback period:

The correct answer is Option 1 - Fails to incorporate time value of money and does not consider cash flows after payback period.

This method can be used when there are unequal cash flows. Also, this method does not use the minimum required rate of return at all. Hence, they are not limitations.

b. Payback period:

Cash flows	Project A	Project B	Project C
Year 0 (Net investment)	6000000	4000000	8000000
Year 1	2050000	1100000	4700000
Year 2	2050000	2300000	4700000
			9400000
Year 3	2050000	700000	50000
	6150000	4100000
Year 4	2050000	25000	0

It implies that for project A, the initial net investment is recovered in 2 years + (1900000/2050000*12) = 2 years and 11 months = 2.96 years

It implies that for project B, the initial net investment is recovered in 2 years + (600000/700000*12) = 2 years and 10.28 months = 2.83 years

It implies that for project C, the initial net investment is recovered in 1 year + (1400000/4700000*12) = 1 year and 3.57 months = 1.3 years

2. NPV of projects:

NPV = Present Value of cash outflows - Present value of cash inflows

Cash flows	Project A	Present Value factor at 8%	Present Value factor	Present Value
Year 0 (Net investment)	-6000000	1	1	-6000000
Year 1	2050000	1/(1.08^1)	0.9259	1898148.148
Year 2	2050000	1/(1.08^2)	0.8573	1757544.582
Year 3	2050000	1/(1.08^3)	0.7938	1627356.094
Year 4	2050000	1/(1.08^4)	0.7350	1506811.198
				789860.0221
Cash flows	Project B	Present Value factor at 8%	Present Value factor	Present Value
Year 0 (Net investment)	-4000000	1	1	-4000000
Year 1	1100000	1/(1.08^1)	0.9259	1018518.519
Year 2	2300000	1/(1.08^2)	0.8573	1971879.287
Year 3	700000	1/(1.08^3)	0.7938	555682.5687
Year 4	25000	1/(1.08^4)	0.7350	18375.74632
				-435543.8798
Cash flows	Project C	Present Value factor at 8%	Present Value factor	Present Value
Year 0 (Net investment)	-8000000	1	1	-8000000
Year 1	4700000	1/(1.08^1)	0.9259	4351851.852
Year 2	4700000	1/(1.08^2)	0.8573	4029492.455
Year 3	50000	1/(1.08^3)	0.7938	39691.61205
Year 4	0	0	0.0000	0
				421035.9193