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 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%
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