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Chapter 4: Q6BP (page 408)

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 alternatives would you select under the payback method?

Short Answer

Expert verified

Answer

The business entity must select product X because it has a lower payback period than product Y.

Step by step solution

01

Definition of Payback Period

Payback method is the matric used in the capital budgeting techniques to determine the time taken by investment to cover the amount of investment made by the company by using the cash flows from the project.

02

Decision investment based on payback period

Calculation of payback period for product X:

Paybackperiod=Periodbeforefullrecovery+AmountrecoveredinperiodCashflowinlastinperiod=3+$10,000$20,000=3+0.5=3.5years

Calculation of payback period for Product Y:

Paybackperiod=Periodbeforefullrecovery+AmountrecoveredinperiodCashflowinlastinperiod=3+$10,000$70,000=3+0.86=3.9years

Therefore, the business entity must select product X.

Working note:

Year

Cash flow of product X

Accumulated cash flow of product X

Cash flow of product Y

Accumulated cash flow of product Y

1

$90,000

$90,000

$50,000

$50,000

2

90,000

$180,000

80,000

$130,000

3

60,000

$240,000

60,000

$190,000

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Most popular questions from this chapter

The Suboptimal Glass Company uses a process of capital rationing in its decision making. The firm鈥檚 cost of capital is 10 percent. It will only invest \(77,000 this year. It has determined the internal rate of return for each of the following projects:

Project

Project size

Internal rate of return

A

\)10,500

21%

B

30,500

22

C

25,500

18

D

10,500

13

E

10,500

20

F

20,500

11

G

10,500

16

a. Select the projects that the firm should accept.

b. If Projects A and B are mutually exclusive, how would that affect your overall answer? That is, which projects would you accept in spending the $77,000?

Dixie Dynamite Company is evaluating two methods of blowing up old buildings for commercial purposes over the next five years. Method one (implosion) is relatively low in risk for this business and will carry a 12 percent discount rate. Method two (explosion) is less expensive to perform but more dangerous and will call for a higher discount rate of 16 percent. Either method will require an initial capital outlay of \(75,000. The inflows from projected business over the next five years are shown next. Which method should be selected using net present value analysis?

Year Method 1 Method 2

1 .................................... \)18,000 $20,000

2 .................................... 24,000 25,000

3 .................................... 34,000 35,000

4 .................................... 26,000 28,000

5 .................................... 14,000 15,00

Explain how the collections and purchases schedules are related to the borrowing needs of the corporation

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

Cashflow

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?

Katie Pairy Fruits Inc. has a \(1,000 20-year bond outstanding with a nominal yield of 15 percent (coupon equals 15% x \)1,000 5 \(150 per year). Assume that the current market required interest rate on similar bonds is now only 12 percent.

a. Compute the current price of the bond.

b. Find the present value of 3 percent x \)1,000 (or \(30) for 20 years at 12 percent. The \)30 is assumed to be an annual payment. Add this valueto $1,000.

c. Explain why the answers in parts a and b are basically the same. (There is a slight difference due to rounding in the tables.)
See all solutions

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