Question

Construction is analyzing its capital expenditure proposals for the purchase of equipment in the coming year. The capital budget is limited to $5,000,000

for the year Lemon Baker​,

staff analyst at Hafners​

is preparing an analysis of the three projects under consideration by Corey Hafners​, the​ company's owner.

Projected cash outflow   Project A Project B Project C

Net initial investment $3,000,000 $2,100,000 $3,000,000

Projected cash inflows

Year 1 $1,200,000 $1,200,000 $1,700,000

Year 2 1,200,000 600,000 1,700,000

Year 3 1,200,000 500,000 200,000

Year 4 1,200,000 100,000

Required rate of return 12% 12% 12%

Requirement 1. Because the​ company's cash is​ limited,

Hafners

thinks the payback method should be used to choose between the capital budgeting projects.

a. What are the benefits and limitations of using the payback method to choose between​ projects?

Benefits of the payback​ method:

A.

Easy to understand and captures uncertainty about expected cash flows in later years of a project

B.

Utilizes the time value of money and computes each​ project's unique rate of return

C.

Indicates whether or not the project will earn the​ company's minimum required rate of return

D.

All of the above

Limitations of the payback​ method:

A.

Cannot be used for projects with unequal periodic cash flows

B.

Cannot be used when​ management's required rate of return varies from one period to the next.

C.

Fails to incorporate the time value of money and does not consider a​ project's cash flows after the payback period

D.

All of the above

b. Calculate the payback period for each of the three projects. Ignore income taxes. ​(Round your answers to two decimal​ places.)

Project A		years
Project B		years
Project C		years

Using the payback​ method, which​ project(s) should

HafnersHafners

​choose?

▼

Projects A, B, and C

Project A

Projects A and C

Project B

Projects B and C

Projects A and B

Project C

Requirement 2. Calculate the NPV for each project. Ignore income taxes. ​(Round your answers to the nearest whole dollar. Use parentheses or a minus sign for negative net present​values.)

The NPV of Project A is $

.

The NPV of Project B is $

.

The NPV of Project C is $

.

Requirement 3. Which​ projects, if​ any, would you recommend​ funding? Briefly explain why.

The

▼

NPV

payback

method is generally regarded as the preferred method for project selection​ decisions, therefore, the company should consider investing in the​ project(s) with

▼

a negative NPV.

a payback under 2 years.

a positive NPV.

the shortest payback period.

Since the​ company's is limited by the

▼

number of capital investments

total dollar value of capital investments

it can make during the​ year, if more than one project fits this​ criteria, they should choose the​investment(s) with the

▼

greatest cash flow afer year 1 of the project.

greatest NPV.

greatest payback period.

lowest NPV.

shortest payback period.

Prior to making a final​ decision, the company should also consider the nonfinancial qualitative factors of the investments such as the

▼

AARR and IRR.

fluctuations in the required rate of return.

the affect of inflation of the NPV calculations.

worker safety issues and customer confidence.

Using only the NPV calculations from requirement​ 2,

HafnersHafners

should invest in

▼

Project C

Project B

Projects B and C

Project A

Projects A and C

Projects A and B

.

Answer 1

Payback period is the time period in which the initial investment is recovered

Benefits of payback method

A. Easy to understand and captures uncertainty about expected cash flows in later years of a project

It does not take into account time value of money and does not talk about rate of return

Limitations

C. Fails to incorporate the time value of money and does not consider a​ project's cash flows after the payback period

Calculation of payback period:

Project A = 3,000,000/1,200,000 = 2.5 years

Project B:

Year	Cash Flows	Cumulative Cash flows
0	(2,100,000)	(2,100,000)
1	1,200,000	(900,000)
2	600,000	(300,000)
3	500,000	200,000
4	100,000	300,000

Payback period = 2 + 300,000/500,000

= 2.6 years

Project C:

Year	Cash Flows	Cumulative Cash flows
0	(3,000,000)	(3,000,000)
1	1,700,000	(1,300,000)
2	1,700,000	400,000
3	200,000	600,000

Payback period = 1 + 1,300,000/1,700,000

= 1.76 years

Because of budget, only one project can be accepted

It will be Project C