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# 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%

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