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Home Capital Budgeting Decisions Review Problem 2: Comparison of capital budgeting methods

 

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:

  1. Compute the net annual cash inflow from the project.
  2. Compute the project's net present value. Is the project acceptable?
  3. Find the project's internal rate of return to the nearest whole percent.
  4. 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%

You may also be interested in other articles from "capital budgeting decisions" chapter:

  1. Capital Budgeting - Definition and Explanation
  2. Typical Capital Budgeting Decisions
  3. Time Value of Money
  4. Screening and Preference Decisions
  5. Present Value and Future Value - Explanation of the Concept
  6. Net Present Value (NPV) Method in Capital Budgeting Decisions
  7. Internal Rate of Return (IRR) Method - Definition and Explanation
  8. Net Present Value (NPV) Method Vs Internal Rate of Return (IRR) Method
  9. Net Present Value (NPV) Method - Comparing the Competing Investment Projects
  10. Least Cost Decisions
  11. Capital Budgeting Decisions With Uncertain Cash Flows
  12. Ranking Investment Projects
  13. Payback Period Method for Capital Budgeting Decisions
  14. Simple rate of Return Method
  15. Post Audit of Investment Projects

  16. Inflation and Capital Budgeting Analysis
  17. Income Taxes in Capital Budgeting Decisions
  18. Review Problem 1: Basic Present Value Computations
  19. Review Problem 2: Comparison of Capital Budgeting Methods
  20. Future Value and Present Value Tables

 

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