Review Problem 2: Comparison of Capital Budgeting Methods
Lamer company is studying a project that
would have an eight-year life and require a $2,400,000 investment in
equipment. At the end of eight years, the project would terminate and
equipment would have no salvage value. The project would provide net
operating income each year as follows:
| Sales |
|
$3,000,000 |
| Less variable expenses |
|
1,800,000 |
| |
|
|
| Contribution margin |
|
1,200,000 |
| Less fixed expenses: |
|
|
| Advertising,
salaries, and other fixed out of pocket costs |
$700,000 |
|
| Depreciation |
300,000 |
|
| |
|
|
| Total fixed expenses |
|
1,000,000 |
| |
|
|
| Net operating income |
|
$200,000 |
| |
|
|
The company's discount rate is 12%.
Required:
- Compute the net annual cash inflow from
the project.
- Compute the project's net present value.
Is the project acceptable?
- Find the project's internal rate of
return to the nearest whole percent.
- Compute the project's simple rate of
return.
Solution to Review Problem:
1. The net annual cash inflow
can be computed by deducting the cash expenses from sales:
| Sales |
$3,000,000 |
| Less variable expenses |
1,800,000 |
| |
|
| Contribution margin |
1,200,000 |
| Advertising, salaries, and
other fixed out of pocket costs |
700,000 |
| |
|
| Net annual cash inflow
|
$500,000 |
| |
|
Or it can be computed by adding
depreciation back to net operating income.
| Net operating income |
$200,000 |
| Add: Non cash deduction
for depreciation |
300,000 |
| |
|
| |
$500,000 |
| |
|
2. The net present value (NPV) can be
computed as follows:
|
Item |
Year(s) |
Amount of Cash Flows |
12% Factor |
Present Value of Cash Flows |
| Cost of new
equipment |
Now |
$(2,400,000) |
1.000 |
$(2,400,000) |
| Net annual
cash inflow |
1-8 |
500,00 |
4.968 |
2,484,000 |
| |
|
|
|
|
| Net present
value |
|
|
|
$84,000 |
| |
|
|
|
|
Yes, the project is acceptable since it has
a positive net present value.
3. The formula or Equation for
computing the factor of the internal rate of return is:
Factor of the internal rate
of return = Investment required / Net annual cash inflow
=$2,400,000 / $500,000
= 4.800
Looking in table-4 at Future Value and Present
Value Tables Page and scanning along the 8-period line, we find that a
factor of 4.800 represents a rate of return of about 13%.
4. The formula for the payback period
is:
The formula for the payback period is:
Payback period = Investment
required / Net annual cash inflow
= $2,400,000 / $500,000
= $4.8 years
5. The formula for the simple rate of
return is:
Simple rate of return =
(Incremental revenue - Incremental expenses including depreciation = Net
operating income) / Initial investment
$200,000 / $2,400,000
= 8.3%
|
