Question

Payback, NPV, Managerial Incentives, Ethical Behavior

Kent Tessman, manager of a Dairy Products Division, was pleased with his division’s performance over the past three years. Each year, divisional profits had increased, and he had earned a sizable bonus. (Bonuses are a linear function of the division’s reported income.) He had also received considerable attention from higher management. A vice president had told him in confidence that if his performance over the next three years matched his first three, he would be promoted to higher management.

Determined to fulfill these expectations, Kent made sure that he personally reviewed every capital budget request. He wanted to be certain that any funds invested would provide good, solid returns. (The division’s cost of capital is 10 percent.) At the moment, he is reviewing two independent requests. Proposal A involves automating a manufacturing operation that is currently labor intensive. Proposal B centers on developing and marketing a new ice cream product. Proposal A requires an initial outlay of $250,000, and Proposal B requires $312,500. Both projects could be funded, given the status of the division’s capital budget. Both have an expected life of six years and have the following projected after-tax cash flows:

Year	Proposal A	Proposal B
1	$150,000	$(37,500)
2	125,000	(25,000)
3	75,000	(12,500)
4	37,500	212,500
5	25,000	275,000
6	12,500	337,500

Answer 1

(1)-Payback Period Analysis

Payback Period – Proposal A

Year	Cash Flows	Cumulative net Cash flow
0	-2,50,000	-2,50,000
1	1,50,000	-1,00,000
2	1,25,000	25,000
3	75,000	1,00,000
4	37,500	1,37,500
5	25,000	1,62,500
6	12,500	1,75,000

Payback Period = Years before full recover + (Unrecovered cash inflow at start of the year/cash flow during the year)

= 1 Year + ($100,000 / 125,000)

= 1 Year + 0.80 years

= 1.80 Years

Payback Period – Proposal B

Year	Cash Flows	Cumulative net Cash flow
0	-3,12,500	-3,12,500
1	-37,500	-3,50,000
2	-25,000	-3,75,000
3	-12,500	-3,87,500
4	2,12,500	-1,75,000
5	2,75,000	1,00,000
6	3,37,500	4,37,500

Payback Period = Years before full recover + (Unrecovered cash inflow at start of the year/cash flow during the year)

= 4 Year + ($175,000 / 275,000)

= 4 Year + 0.64 years

= 4.64 Years

(2)-Net Present Value (NPV) Analysis

Net Present Value – Proposal A

Year	Annual Cash Flow	Present Value factor at 10%	Present Value of Cash Flow
1	1,50,000	0.90909	1,36,363.64
2	1,25,000	0.82645	1,03,305.79
3	75,000	0.75131	56,348.61
4	37,500	0.68301	25,613.00
5	25,000	0.62092	15,523.03
6	12,500	0.56447	7,055.92
TOTAL			$3,44,209.99

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $3,44,209.99 – 250,000

= $94,209.99

Net Present Value – Proposal B

Year	Annual Cash Flow	Present Value factor at 10%	Present Value of Cash Flow
1	-37,500	0.90909	-34,090.91
2	-25,000	0.82645	-20,661.16
3	-12,500	0.75131	-9,391.44
4	2,12,500	0.68301	1,45,140.36
5	2,75,000	0.62092	1,70,753.36
6	3,37,500	0.56447	1,90,509.95
TOTAL			$4,42,260.17

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $4,42,260.17 – 312,500

= $1,29,760.17

DECISION

As per Payback Period Analysis, The Proposal A is better since the Project will payback win 1.80 years and as per NPV method analysis, the Proposal B is better since it has the higher NPV of $1,29,760.17