Review Problem 2: Comparison of Capital Budgeting Methods

Lamer company is studying a project that would have an eight-year 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:

The company's discount rate is 12%.

Required:

1. Compute the net annual cash inflow from the project.
2. Compute the project's net present value. Is the project acceptable?
3. Find the project's internal rate of return to the nearest whole percent.
4. 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:

Or it can be computed by adding depreciation back to net operating income.

2. The net present value (NPV) can be computed as follows:

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 table-4 at Future Value and Present Value Tables Page and scanning along the 8-period 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%

 

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