Answers - Capital Budgeting
2 (a). Payback period is the time or period it will take to obtain the amount of initial investment invested in a given project or investment.
(b). The return of investment is the percentage periodic return received back from a given investment.
(c). The Net present value is the difference between the present value of all future cash flows and the investment amount.
3. Payback period does not consider or include the time value of money.
4. NPV considers and includes time value of money in its formula.
5. Qualitative methods used in decision-making process:
• Economic factors
• Other alternative projects
• Political factors
6. A positive NPV indicates that the investment is profitable and thus, projects with a positive NPV should be accepted. A negative NPV indicates that an investment is not worthy investing and thus, projects with a negative NPV should be rejected.
7 (a). Payback period = amount of investment / net cash flow in a period
= 60,000 /10,000
= 6 years
(b). Return on average investment = average annual net income / average investment
=10,000 / 40,000 (note average investment = (60,000+20,000)/2)
= 0.25 or 25%
8 (a). Payback period = 4 Years. Please see table below how the answer was obtained.
| Year | Net Cash Flow | Total Net Cash Flow |
|---|---|---|
| Year 1 | $120,000 | $120,000 |
| Year 2 | $150,000 | $270,000 |
| Year 3 | $160,000 | $430,000 |
| Year 4 | $170,000 | $600,000 |
| Year 5 | $100,000 | $700,000 |
(b). NPV = − 130,111.99. Please see the table below how the answer was obtained.
| Year | Net Cash Flow | Present Value Factor (15%) | Present Value |
|---|---|---|---|
| Year 0 | $600,000 | 1 | ($600,000) |
| Year 1 | $120,000 | 0.86957 | $104,348.40 |
| Year 2 | $150,000 | 0.75614 | $113,421.00 |
| Year 3 | $160,000 | 0.65752 | $105,203.20 |
| Year 4 | $170,000 | 0.57175 | $97,197.50 |
| Year 5 | $100,000 | 0.49718 | $49,718.00 |
| NPV | ($130,111.99) |
NPV = Present value of all future cash flows − initial investment
NPV = 469,888.01 - 600,000
= (130,111.99)
9. Payback period = amount of investment / net cash flow in a period
Net cash flow = amount of investment / payback period
= 250,000 /5
= $50,000
10 (a). Supplier 1: Payback period = amount of investment / net cash flow in a period
= 150,000 / 50,000
= 3 Years
Supplier 2: Payback period = amount of investment / net cash flow in a period
=100,000 / 25,000
= 4 Years
(b). Supplier 1:
PV = Cash flow x PV Factor (10% for 4yrs)
PV = 200,000 x 3.1699
PV = 633,980
NPV = Present value − initial investment
NPV = 633,980 − 150,000
NPV = 483,980
Supplier 2:
PV = Cash flow x PV Factor (10% for 4yrs)
PV = 100,000 x 3.1699
PV = 316,990
NPV = Present value − initial investment
NPV = 316,990 − 100,000
NPV = 216,990
(c). Medical Experts Inc. should choose supplier 1 because it will obtain higher returns than supplier 2. NPV of supplier 1 is more than supplier 2.