Heart Construction is analyzin
Heart Construction is analyzing its capital expenditureproposals for equipment in the coming year. The capital budget islimited to $15,000,000 for the year. Laura, staff analyst at HeartConstruction, is preparing an analysis of the three projects underconsideration by Mr. Heart, the company’s owner.
|
Project A |
Project B |
Project C |
|
|
Net initial investment |
$6,600,000 |
$8,500,000 |
$9,000,000 |
|
Year 1 cash inflows |
3,600,000 |
5,500,000 |
4,900,000 |
|
Year 2 cash inflows |
3,600,000 |
2,000,000 |
4,900,000 |
|
Year 3 cash inflows |
3,600,000 |
1,100,000 |
200,000 |
|
Year 4 cash inflows |
3,600,000 |
0 |
100,000 |
|
Required rate of return |
6% |
6% |
6% |
Because the company’s cash is limited, Mr. Heart thinks thepayback method should be used to choose between the capitalbudgeting projects.
Requirement
- What are the benefits of the payback methods?
- What are the limitations of the payback methods?
- Calculate the payback period for each of the three projects.Ignore income taxes. Round your answer to 2 decimal places.
- Based on the payback period, which project should Mr. Heartchoose?
- Calculate the simple rate of return for each project. Ignoreincome taxes.
- Based on the simple rate of return, which project should Mr.Heart choose?
Answer:
HI Frind,
Please see below solution for the question asked above:Thanks
Payback Period is the time where a project’s net cashinflows are equal to the project’s initial cash investment. Thismethod is often used as the initial screen process and helps todetermine the length of time required to recover the initial cashoutlay (investment) in the project.
The main advantages of the payback period are as follows:
- A longer payback period indicates capital is tied up.
- Focus on early payback can enhance liquidity
- Investment risk can be assessed through the payback method
- Shorter-term forecasts
- This is a more reliable technique
- The calculation process is quicker than and simple than anyother appraisal techniques
- This is a very easily understood concept
There are numbers of serious drawbacks to the payback PeriodMethod:
- It ignores the timing of cash inflows within the paybackperiod
- It ignores the cash flow produced after the end of the paybackperiod and therefore the total return of the project.
- It ignores the time value of money
- Its influences for excessive investment in short termprojects.
- (for the practical solution refer answer sheet attached)
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