Review Problem 2: Comparison of Capital Budgeting Methods
Lamer company is studying a project that
would have an eightyear 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 
18 
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 table4 at Future Value and Present
Value Tables Page and scanning along the 8period 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%
