Question

Cash Payback Period, A method of analysis of proposed capital investments that focuses on the present value of the cash flows expected from the investments.Net Present Value Method, and Analysis

Elite Apparel Inc. is considering two investment projects. The estimated net cash flows from each project are as follows:

Year Plant Expansion Retail Store Expansion

1 $162,000 $135,000

2 132,000 159,000

3 114,000 109,000

4 103,000 76,000

5 33,000 65,000

Total $544,000 $544,000

Each project requires an investment of $294,000. A rate of 15% has been selected for the net present value analysis.

Present Value of $1 at Compound Interest

Year 6% 10% 12% 15% 20%

1 0.943 0.909 0.893 0.870 0.833

2 0.890 0.826 0.797 0.756 0.694

3 0.840 0.751 0.712 0.658 0.579

4 0.792 0.683 0.636 0.572 0.482

5 0.747 0.621 0.567 0.497 0.402

6 0.705 0.564 0.507 0.432 0.335

7 0.665 0.513 0.452 0.376 0.279

8 0.627 0.467 0.404 0.327 0.233

9 0.592 0.424 0.361 0.284 0.194

10 0.558 0.386 0.322 0.247 0.162

Required:

1a. Compute the cash payback period for each project.

Cash Payback Period

Plant Expansion

1 year

2 years

3 years

4 years

5 years

Retail Store Expansion

1 year

2 years

3 years

4 years

5 years

1b. Compute the net present value. Use the present value of $1 table above. If required, round to the nearest dollar.

Plant Expansion Retail Store Expansion

Total present value of net cash flow $ $

Less amount to be invested

Net present value $ $

2. Because of the timing of the receipt of the net cash flows, the

plant expansion

retail store expansion

offers a higher

net present value

net cash flow

Answer 1

payback period and net present value are capital budgeting techniques used to determine which project should be selected.

project with higher NPV and lower Payback period is always better.

(1) Payback period is the time period within which initial invested money is regained back in form of cash inflow.

it does not consider time value of money.

Plant expansion

initial investment = $294,000

years	cash inflow	cumulative cash inflow
1	$162,000	$162,000
2	$132,000	$294,000 [162,000+132,000]
3	$114,000	$408,000 [294000+114000]
4	$103,000	$511,000[408000+103000]
5	$33,000	$544,000[511000+33000]

payback period = 2 years

as the cumulative cash flow at the end of year 2 = initial investment

Retail store expansion

years	cash inflow	cumulative cash inflow
1	$135,000	$135,000
2	$159,000	$294,000 [135,000+159,000]
3	$109,000	$403,000 [294000+109000]
4	$76,000	$479,000[408000+103000]
5	$65,000	$544,000[479000+65000]

payback period = 2 years

as the cumulative cash flow at the end of year 2 = initial investment

(2) NET PRESENT VALUE is difference between initial investment and present value of cash inflow.

present value = future value / (1+r)ⁿ

^{plant expansion}

years	cash flow	pv factor 15%	Present value of cash flow
0	($294,000)	1	($294,000)
1	$162,000	0.870	$140,940[162000*0.870]
2	$132,000	0.756	$99,792[132000*0.756]
3	$114,000	0.658	$75,012[114000*0.658]
4	$103,000	0.572	$58,916[103000*0.572]
5	$33,000	0.497	$16,401[33000*0.497]
		Net present value [140,940+99,792+75,012+58,916+16,401-294000]	$391,061

Retail divsion

years	cash flow	pv factor 15%	Present value of cash flow
0	($294,000)	1	($294,000)
1	$135000	0.870	$117,450
2	$159000	0.756	$120,204
3	$109000	0.658	$71,722
4	$76000	0.572	$43,472
5	$65000	0.497	$32,305
		Net present value [117,450+120,204+71,722+43,472+32,305]	$91,153

both the project (Plant & Retail) have same total cash inflow and payback period, However plant expansion will regain higher cash flows in earlier period. so its NPV is higher because $1 today is worth more than $1 tomorrow due to interest factor.

So, Plant expansion offers a higher Net present value.