Question

Assignment: Capital Budgeting Decisions Your company is considering undertaking a project to expand an existing product line. The required rate of return on the project is 8% and the maximum allowable payback period is 3 years.
time 0 1 2 3 4 5 6
Cash flow $ 10,000 2,400 4,800 3,200 3,200 2,800 2,400
Evaluate the project using each of the following methods. For each method, should the project be accepted or rejected? Justify your answer based on the method used to evaluate the project’s cash flows.
A. Payback period
B. Internal Rate of Return (IRR)
C. Simple Rate of Return
D. Net Present Value

Answer 1

Answer:

A. Payback period

• payback period = 2.875 years, therefore, the project should be accepted because the payback period is less than 3 years.

B. Internal Rate of Return (IRR)

• IRR = 22.69%, therefore, the project should be accepted since the IRR is higher than the required rate of return (8%).  

C. Simple Rate of Return

• simple rate of return = 18%, therefore, the project should be accepted because the simple rate of return is higher than the required rate of return.

D. Net Present Value

• NPV = $4,647.85 , therefore, the project should be accepted since the NPV is positive.

Explanation:

year          cash flow

0                -$10,000

1                  $2,400

2                 $4,800

3                 $3,200

4                 $3,200

5                 $2,800

6                 $2,400

discount rate 8%

I used a financial calculator to determine the NPV and IRR.

Payback period = $10,000 - $2,400 - $4,800 = $2,800 / $3,200 = 0.875

payback period = 2.875 years

simple rate of return:

average cash flow = ($2,400 + $4,800 + $3,200 + $3,200 + $2,800 + $2,400) / 6 = $3,467

depreciation expense per year = $10,000 / 6 = $1,667

simple rate of return = ($3,467 - $1,667) / $10,000 = 18%