Question

Problem 25-01A U3 Company is considering three long-term capital investment proposals. Each investment has a useful life of 5 years. Relevant data on each project are as follows. Project Bono $171,200 Project Edge $187,250 Project Clayton $206,000 Capital investment Annual net income: Year 1 NM in 14,980 14,980 14,980 14,980 14,980 $74,900 19,260 18,190 17,120 12,840 9,630 $77,040 28,890 24,610 22,470 13,910 12,840 $102,720 Total Depreciation is computed by the straight-line method with no salvage value. The company's cost of capital is 15%. (Assume that cash flows occur evenly throughout the year.) Click here to view the factor table.

Answer 1

Payback period is number of years it takes for company to earn the cash invested in projects
Calculation of payback period for Project Bono
Project Bono	Capital investment/Annual cash flow
Annual cash flow
Annual net income	$14,980
Add: Depreciation	$34,240	171200/5
Annual cash flow	$49,220
Project bono	171200/49220
Project bono	3.48	years
Project Edge
Year	Net income	Depreciation (187250/5)	Cash flow	Cumulative cash flow
0			-$187,250	-$187,250
1	$19,260	$37,450	$56,710	-$130,540
2	$18,190	$37,450	$55,640	-$74,900
3	$17,120	$37,450	$54,570	-$20,330
4	$12,840	$37,450	$50,290	$29,960
5	$9,630	$37,450	$47,080	$77,040
Payback period	3 years + (20330/50290)
Payback period	3.40	years
Project Clayton
Year	Net income	Depreciation (206000/5)	Cash flow	Cumulative cash flow
0			-$206,000	-$206,000
1	$28,890	$41,200	$70,090	-$135,910
2	$24,610	$41,200	$65,810	-$70,100
3	$22,470	$41,200	$63,670	-$6,430
4	$13,910	$41,200	$55,110	$48,680
5	$12,840	$41,200	$54,040	$102,720
Payback period	3 years + (6430/55110)
Payback period	3.12	years
Net present value is calculated as present value of cash inflow less present value of cash outflow
Project Bono
Year	Cash flow	Discount factor @ 15%	Present value
0	-$171,200	1	-$171,200		1.00000
1	$49,220	0.86957	$42,800		0.86957
2	$49,220	0.75614	$37,217		0.75614
3	$49,220	0.65752	$32,363		0.65752
4	$49,220	0.57175	$28,142		0.57175
5	$49,220	0.49718	$24,471		0.49718
Net present value			-$6,207
Project Edge
Year	Cash flow	Discount factor @ 15%	Present value
0	-$187,250	1	-$187,250
1	$56,710	0.86957	$49,313
2	$55,640	0.75614	$42,072
3	$54,570	0.65752	$35,881
4	$50,290	0.57175	$28,753
5	$47,080	0.49718	$23,407
Net present value			-$7,824
Project Clayton
Year	Cash flow	Discount factor @ 15%	Present value
0	-$206,000	1	-$206,000
1	$70,090	0.86957	$60,948
2	$65,810	0.75614	$49,762
3	$63,670	0.65752	$41,864
4	$55,110	0.57175	$31,509
5	$54,040	0.49718	$26,868
Net present value			$4,951
Annual rate of return	Average annual net income/Average investment
Project Bono
Annual rate of return	(74900/5)/((171200+0)/2)
Annual rate of return	14980/85600
Annual rate of return	17.50%
Project Edge
Annual rate of return	(77040/5)/((187250+0)/2)
Annual rate of return	15408/93625
Annual rate of return	16.46%
Project Clayton
Annual rate of return	(102720/5)/((206000+0)/2)
Annual rate of return	20544/103000
Annual rate of return	19.95%
Ranking of project
	Cash payback	Net present value	Annual rate of return
Bono	3	2	2
Edge	2	3	3
Clayton	1	1	1
The best project is Clayton