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Chapter 26: Q2SE (page 1465)

S26-2 Using payback to make capital investment decisions

Carter Company is considering three investment opportunities with the following payback periods:

Project A

Project B

Project C

Payback period

2.7 years

6.4 years

3.8 years

Use the decision rule for payback to rank the projects from most desirable to least desirable, all else being equal.

Short Answer

Expert verified

Rank

Project

1

A

2

C

3

B

Step by step solution

01

Definition of Capital Investment

The investment made by the business entity to acquire the fixed/plant assets to be employed in the business operations is known as capital investment.

02

Ranking of projects

The payback period defines the period in which the project will repay the amount initially invested. Project A is given 1st rank because it will repay the amount at the earliest compared to other projects. At the same time, project B is provided with 3rd rank because it will repay the initial investment after 6.4 years which is higher than the other two projects.

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Most popular questions from this chapter

Henry Hardware is adding a new product line that will require an investment of \(1,512,000. Managers estimate that this investment will have a 10-year life and generate net cash inflows of \)310,000 the first year, \(270,000 the second year, and \)240,000 each year thereafter for eight years. Compute the payback period. Round to one decimal place.

Henry Co. is considering acquiring a manufacturing plant. The purchase price is \(1,200,000. The owners believe the plant will generate net cash inflows of \)325,000 annually. It will have to be replaced in six years. Use the payback method to determine whether Henry should purchase this plant. Round to one decimal place.

Question: What is an annuity? How does it differ from a lump sum payment?

You are planning for early retirement. You would like to retire at age 40 and have enough money saved to be able to withdraw \(220,000 per year for the next 30 years (based on family history, you think you will live to age 70). You plan to save by making 20 equal annual instalments (from age 20 to age 40) into a fairly risky investment fund that you expect will earn 8% per year. You will leave the money in this fund until it is completely depleted when you are 70 years old.

Requirements

1. How much money must you accumulate by retirement to make your plan work? (Hint: Find the present value of the \)220,000 withdrawals.)

2. How does this amount compare to the total amount you will withdraw from the investment during retirement? How can these numbers be so different?

What is the decision rule for ARR?
See all solutions

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