Question

In this case I want you to do some small capital budgeting projects. They are very minimal but will give you a better idea of how firms forecast and analyze to make decisions. The three tools are Payback Method, NPV, IRR.

#1 Payback Method You want to purchase an expensive sonography machine that costs $200,000. Ignoring the time value of money and the cost of capital what would your payback period be if you had these cash flows over the next 4 years

initial outlay year 1   year 2 year 3   year 4

($200,000) $60,000 $60,000 $60,000 $60,000

#2 Net Present Value Method

You are deciding to purchase another piece of x-ray equipment for $5,000 and the cost of capital is 12%. Determine the present value of the cash flows and the NPV to determine if the equipment is a good investment. Hint: use present value table 12% as a factor.

Year Cash Flow

0 ($5,000)

1   $1,000

2 $2,000

3 $3,000

#3 Use the scenario and cash flows above to find the Internal Rate of Return (IRR) of the project. Explain why or why not the investment should be accepted based on the IRR.

Answer 1

1: Cumulative cashflow are as below

Year	Project A	Cumulative cash flow
0	-200000	-200000
1	60000	-140000
2	60000	-80000
3	60000	-20000
4	60000	40000

Payback = Year in which cumulative CF is last negative + (-Cumulative CF/CF of next year)

= 3+ (20000/60000)

=3.33 years

2: NPV= C0+ CF1/(1+r)^1 + CF2/(1+r)^2 …………CFn/(1+r)^n

= -5000+ 1000/1.12^1+ 2000/1.12^2+ 3000/1.12^3

= -377.41

3: IRR as per excel

= 8.21%

Since this is lesser than the cost of capital of 12%, the project shouldnot be accepted

WORKINGS