Question

RozzisRozzis

Construction is analyzing its capital expenditure proposals for the purchase of equipment in the coming year. The capital budget is limited to

$ 5 comma 000 comma 000$5,000,000

for the year.

LindaLinda

BensonBenson?,

staff analyst at

RozzisRozzis?,

is preparing an analysis of the three projects under consideration by

ChesterChester

RozzisRozzis?,

the? company's owner.

Requirement 1. Because the? company's cash is? limited,

RozzisRozzis

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.

Cannot be used when? management's required rate of return varies from one period to the next.

B.

Cannot be used for projects with unequal periodic cash flows

C.

Fails to incorporate the time value of money and does not consider a? project's cash flows after the payback period

D.

All of the above

Data Table:

Project A

Project B

Project C

Projected cash outflow

Net initial investment

$3,000,000

$2,100,000

$3,000,000

Projected cash inflows

Year 1

$1,200,000

$1,200,000

$1,700,000

Year 2

1,200,000

600,000

1,700,000

Year 3

1,200,000

500,000

200,000

Year 4

1,200,000

100,000

Required rate of return

8%

8%

8%

Requirements:

1.	Because the? company's cash is? limited, RozzisRozzis 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?
	b.	Calculate the payback period for each of the three projects. Ignore income taxes. Using the payback? method, which projects should RozzisRozzis ?choose?
2.	BensonBenson thinks that projects should be selected based on their NPVs. Assume all cash flows occur at the end of the year except for initial investment amounts. Calculate the NPV for each project. Ignore income taxes.
3.	Which? projects, if? any, would you recommend? funding? Briefly explain why.

Answer 1

1)	Annual incremental cash flows:
	Annual incremental revenues			190000
	Variable costs (15%)			28500
	Fixed costs			80000
	Incremental annual cash flow			81500
	Payback period = Initial investment/Annual cash flow = 178000/81500 =						2.18	Years
	Discounted payback:
	Year	Cash flow	PVIF at 6%	PV at 6%	Cumulative PV
	0	-178000	1.00000	-178000	-178000
	1	81500	0.94340	76887	-101113
	2	81500	0.89000	76888	-24226
	3	81500	0.83962	68429	44203
	4	81500	0.79209	64556	108759
	5	81500	0.74726	60902	169661
	6	81500	0.70496	57454	227115
	7	81500	0.66506	54202	281317
	8	81500	0.62741	51134	332451
	9	81500	0.59190	48240	380691
	Discounted payback period = 2+24226/68429 =				2.35	Years
2)	Payback period:
	Year	Cash flow	Cumulative Cash flow
	0	-178000	-178000
	1	85000	-93000
	2	130000	37000
	3	140000	177000
	4	170000	347000
	5	180000	527000
	6	170000	697000
	7	140000	837000
	8	150000	987000
	9	185000	1172000
	Payback period = 1+93000/130000 =			1.72	Years
	Discounted payback:
	Year	Cash flow	PVIF at 6%	PV at 6%	Cumulative PV
	0	-178000	1.00000	-178000	-178000
	1	85000	0.94340	80189	-97811
	2	130000	0.89000	80190	-17622
	3	140000	0.83962	117547	99925
	4	170000	0.79209	134656	234581
	5	180000	0.74726	134506	369087
	6	170000	0.70496	119843	488931
	7	140000	0.66506	93108	582039
	8	150000	0.62741	94112	676150
	9	185000	0.59190	109501	785652
	Discounted payback period = 2+17622/117547 =				2.15	Years
1)	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
	Limitations of the payback method:
	C.
	Fails to incorporate the time value of money and does not consider a? project's cash flows after the payback period
2)	PROJECT A:
	Year	Cash flow
	0	-3000000
	1	1200000
	2	1200000
	3	1200000
	4	1200000
	Payback period = 3000000/1200000 =			2.50	Years
	PROJECT B:
	Year	Cash flow	Cumulative cash flow
	0	-2100000	-2100000
	1	1200000	-900000
	2	600000	-300000
	3	500000	200000
	4	100000	300000
	Payback period = 2+300000/500000=			2.60	Years
	PROJECT C:
	Year	Cash flow	Cumulative cash flow
	0	-3000000	-3000000
	1	1700000	-1300000
	2	1700000	400000
	3	200000	600000
	4	0	600000
	Payback period = 1+1300000/1700000=			1.76	Years
	Projects should be ranked in the ascending order of payback period.
	Hence, the order of ranking is Project C, Project A and Project B.
	But as available capital is limited to $5000000, only Project C can be
	chosen.
2)	PROJECT A:
	Year	Cash flow	PVIF at 8%	PV at 8%
	0	-3000000	1.00000	-3000000
	1	1200000	0.92593	1111111
	2	1200000	0.85734	1028807
	3	1200000	0.79383	952599
	4	1200000	0.73503	882036
			NPV =	974552
	PROJECT B:
	Year	Cash flow	PVIF at 8%	PV at 8%
	0	-2100000	1.00000	-2100000		`
	1	1200000	0.92593	1111111		`
	2	600000	0.85734	514403
	3	500000	0.79383	396916
	4	100000	0.73503	73503
			NPV =	-4066
	PROJECT C:
	Year	Cash flow	PVIF at 8%	PV at 8%
	0	-3000000	1.00000	-3000000
	1	1700000	0.92593	1574074
	2	1700000	0.85734	1457476
	3	200000	0.79383	158766
	4	0	0.73503	0
			NPV =	190317
3)	Projects A and C are acceptable as they have positive NPV's
	with Project A having Rank 1 and Project C having rank 2.
	But, as available capital is limited, only Project A can be
	implemented.