Chapter-12

The Capital Budgeting Decision

Payback Period (PP):
computes the amount of time required to recoup the initial investment
a cutoff period is established.

6. Assume a $250,000 investment and the following cash flows for two products:
Year Product X Product Y
1 $90,000 $50,000
2 90,000 80,000
3 60,000 60,000
4 20,000 70,000

Which alternative would you select under payback period method?

Solution:
Year Product X Recovering Initial Investment Payback Period
1 $90,000 2,50,000- 90,000 1
2 90,000 1,60,000-90,000 1
3 60,000 70,000-60,000 1
4 20,000 10,000 10,000/20,000= 0.5 0.50
Payback Period = 3.50 years

Year Product Y Recovering Initial Investment Payback Period

1 $50,000 2,50,000 – 50,000 1
2 80,000 2,00,000 - 80,000 1
3 60,000 120,000 – 60,000 1
4 70,000 60,000 60,000/70,000= 0.85 0.85
Payback Period = 3.85 years

I would select product X because it has lower payback period

8. Assume a $90,000 investment and the following cash flows for two alternatives:

Year Investment A Investment B

1 $25,000 $40,000
2 30,000 40,000
3 25,000 28,000
4 19,000 -
5 25,000 -
b) No, My answer would not change, because the cash flow of $25,000,000 is beyond the payback
period.
 
 

 
 
 
18. The Pan American Bottling Co. is considering the purchase of a new machine that would increase the speed of
bottling and save money. The net cost of this machine is $60,000. The annual cash flows have the following
projections:
Year Cash Flow
1 $23,000
2 $26,000
3 $29,000
4 $15,000
5 $8,000

a. If the cost of capital is 13 percent, what is the net present value of selecting a new machine?
b. What is the internal rate of return?
c. Should the project be accepted? Why?
d. Calculate PI for Pan American Bottling Co.
 
 

 
c. The project should be accepted as the net present value is positive and the IRR exceeds the cost of capital. So,
the new machine can be purchased.

 
*** Aerospace Dynamics will invest $110,000 for project A and $100,000 for Project B. Both projects that will
produce the following cash flows.
YearProject A Project B
1 36,000 36,000
2 44,000 44,000
3 38,000 (38,000)
4 (44,000) 44,000
5 81,000 81,000
The firm will also be required to spend $10,000 for Project A and $12,000 for Project B to Close down projects end of
the five years.
a) Which of the two alternatives would you select under the payback method.
b) Calculate NPV for both project if the cost of capital 10 percent.
c) Which of the two alternatives would you select based on the IRR method? To answer, calculate the internal rate of
return for both the projects.
d) Calculate Profitability Index (PI) for both projects.
Comment: which project would you select.
Solution:
a)
Year Project A Recovering Initial Investment Payback Period
1 $36,000 $1,10,000 – 36,000 1
2 $44,000 74,000 – 44,000 1
3 $38,000 30,000/38,000 0.78
4 ($44,000) 2.78 years
5 $81,000

Year Project B Recovering Initial Investment Payback Period

1 36,000 $100,000 – 36,000 1
2 44,000 64,000 – 44,000 1
3 (38,000) 20,000 – (38,000)= 20,000+38,000 1
4 44,000 58,000 – 44,000 1
5 81,000 14,000/81,000=0.17 0.17
4.17 years
 

 
C) As we got a positive NPV @ 10% cost of capital we assume this is the lower rate. So, now we can
assume that our higher rate is 25%. Lets calculate NPV @25%.