Question

Assignment: Capital Budgeting Decisions Your company is considering undertaking a project to expand an existing product line. The required rate of return on the project is 8% and the maximum allowable payback period is 3 years.

time 0 1 2 3 4 5 6
Cash flow $ 10,000 2,400 4,800 3,200 3,200 2,800 2,400
Evaluate the project using each of the following methods. For each method, should the project be accepted or rejected? Justify your answer based on the method used to evaluate the project’s cash flows.
A. Payback period
B. Internal Rate of Return (IRR)
C. Simple Rate of Return
D. Net Present Value

Answer 1

The project should be accepted based on the payback period, internal rate of return (IRR), and simple rate of return methods, but it should be rejected based on the net present value (NPV) method.

Step-by-step explanation:

A. Payback period: To calculate the payback period, we need to determine the time it takes for the cumulative cash flows to equal or exceed the initial investment. In this case, the cumulative cash flows at the end of each year are: $10,000, $12,400, $17,200, $20,400, $23,600, $26,400.

The payback period is the point in time when the cumulative cash flows reach or exceed the initial investment of $10,000. In this case, it takes 3 years, so the project should be accepted.

B. Internal Rate of Return (IRR): The IRR is the discount rate that makes the net present value (NPV) of the project equal to zero.

To calculate the IRR, we find the discount rate that makes the present value of the cash inflows equal to the present value of the initial investment. In this case, the IRR is approximately 40%, which is higher than the required rate of return of 8%.

Therefore, the project should be accepted.

C. Simple Rate of Return: The simple rate of return is the annual net income divided by the initial investment. In this case, the net income for each year is: $2,400, $4,800, $3,200, $3,200, $2,800, $2,400.

The simple rate of return for each year is: 24%, 48%, 32%, 32%, 28%, 24%. Since the simple rate of return is above the required rate of return of 8% for each year, the project should be accepted.

D. Net Present Value: The net present value is the sum of the present values of the cash inflows and outflows. To calculate the net present value, we discount the cash flows at the required rate of return of 8%.

In this case, the present value of the cash flows is: $9,259.26, $1,851.85, $3,703.70, $2,469.14, $2,469.14, $2,145.35. The net present value is the sum of these values minus the initial investment of $10,000, which is approximately -$1,000. Since the net present value is negative, the project should be rejected.

Answer 2

A. Payback period

• payback period = 2.875 years, therefore, the project should be accepted because the payback period is less than 3 years.

B. Internal Rate of Return (IRR)

• IRR = 22.69%, therefore, the project should be accepted since the IRR is higher than the required rate of return (8%).

C. Simple Rate of Return

• simple rate of return = 18%, therefore, the project should be accepted because the simple rate of return is higher than the required rate of return.

D. Net Present Value

• NPV = $4,647.85 , therefore, the project should be accepted since the NPV is positive.

Step-by-step explanation:

year cash flow

0 -$10,000

1 $2,400

2 $4,800

3 $3,200

4 $3,200

5 $2,800

6 $2,400

discount rate 8%

I used a financial calculator to determine the NPV and IRR.

Payback period = $10,000 - $2,400 - $4,800 = $2,800 / $3,200 = 0.875

payback period = 2.875 years

simple rate of return:

average cash flow = ($2,400 + $4,800 + $3,200 + $3,200 + $2,800 + $2,400) / 6 = $3,467

depreciation expense per year = $10,000 / 6 = $1,667

simple rate of return = ($3,467 - $1,667) / $10,000 = 18%