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 | |
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Contribution margin | 1,200,000 | |
Less fixed expenses: | ||
Advertising, salaries, and other fixed out of pocket costs | $700,000 | |
Depreciation | 300,000 | |
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Total fixed expenses | 1,000,000 | |
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Net operating income | $200,000 | |
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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 |
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Contribution margin | 1,200,000 |
Advertising, salaries, and other fixed out of pocket costs | 700,000 |
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Net annual cash inflow | $500,000 |
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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 |
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$500,000 | |
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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 |
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Net present value | $84,000 | |||
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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:
- Capital Budgeting – Definition and Explanation
- Typical Capital Budgeting Decisions
- Time Value of Money
- Screening and Preference Decisions
- Present Value and Future Value – Explanation of the Concept
- Net Present Value (NPV) Method in Capital Budgeting Decisions
- Internal Rate of Return (IRR) Method – Definition and Explanation
- Net Present Value (NPV) Method Vs Internal Rate of Return (IRR) Method
- Net Present Value (NPV) Method – Comparing the Competing Investment Projects
- Least Cost Decisions
- Capital Budgeting Decisions With Uncertain Cash Flows
- Ranking Investment Projects
- Payback Period Method for Capital Budgeting Decisions
- Simple rate of Return Method
- Inflation and Capital Budgeting Analysis
- Income Taxes in Capital Budgeting Decisions
- Review Problem 1: Basic Present Value Computations
- Review Problem 2: Comparison of Capital Budgeting Methods
- Future Value and Present Value Tables
Other Related Accounting Articles:
- Screening Decisions and Preference Decisions
- Simple Rate of Return Method
- Future Value and Present Value Tables
- Capital Budgeting Decisions
- Review Problem 1: Basic Present Value
- Income Tax and Capital Budgeting Decisions
- Present Value and Future Value – Explanation of the Concept
- Profitability Index (PI)
- Capital Expenditure
- Venture Capital Funding
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