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Unformatted text preview: M When the annual cash ﬂows of a project are NOT the same, you can NOT use the above formula to calculate payback period. You must calculate investment coverage year by year (see example 2). How do we use the payback period model to make investment decision? When the payback period of a project is shorter than its expected life of investment,
basically, this project is acceptable. If there are several projects, the one that gives you the shortest payback period should be selected. Two weaknesses of the payback period method are as follows:
I Payback ignores the time value ofmoneyl l Payback ignores the proﬁtability of investments beyond the payback period. Example 1. The city manager of Lincoln is considering two mutually exclusive investment
proposals (they can only choose one proposal) for the town’s water utility. The
following information is available about the projects. Proposal Investment Cost Yearly Cash Expected Life
Inﬂow A $100,000 $20,000 6 years B $120,000 $40,000 5 years Required: a. Compute the payback period for each alternative. ;
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i b. Based on the payback criterion, which of the alternatives is preterred? Why? \. i i  1 ‘_>‘,_ A, _ ‘ .. .. ‘' l
y c. Provide two limitations of the payback period investment analysis ‘ ‘ \(J u l 31 Example 2
A company has two mutually exclusive projects: CAD~A and CAD~B. Both of them require an initial investment of $150,000. Their annual cash inflows are as the following: Projects Year 1 Year 2 Year 3 Year 4 Year 5
CAD—A $ 90,000 $ 60,000 $ 50,000 $ 50,000 $ 50,000
CAD—B 40,000 110,000 25,000 25,000 25,000 Use Payback period method to make your investment decision t\ It»: lit .20 x [l :h‘ i
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A. Future Value The payback period and the accounting rate of return both ignore the time value of money,
Speciﬁcally, they fail to acknowledge the fact that a dollar received today is worth more than a
dollar received one year (or further) in the future. The reason that a dollar received today is
worth more than one received tomorrow is because it can be invested to earn a return. Thus,
the future value of a dollar invested today is the original dollar plus the return (or interest). The
interest can be either simple or compound. The interest is simple if it is paid each interest period,
and it is compound interest if the interest remains invested so that interest is earned on interest.
Compound interest is assumed. B. Present Value For capital budgeting decisions, managers need to know how to convert future cash flows into present values (i.e., how much must be invested now to earn some future amount). This process r . 1' JJt': Example 5. Satchel’s Playtime, a dog daycare company, is considering adding a dog obstacle course to its
play yard. They have obtained the bids from two competing companies that provide dog obstacle
course equipment and have gathered some additional ﬁnancial information. The following is the information they have gathered: Choice 1 Choice 2
Initial investment $23,000 $33,000
Annual additional income $8,000 $8,000
Annual oEerating costs $2,500 $1,200
Maintenance in year 3 $2,300 $1,680 Maintenance in ear 7 $2,000 $750
Salva 6 Value $1,500 $9,800
Discount rate 1 0% Exgected iife 9 years 9 years 1. Calculate Payback for each choice. {3 49: i
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2. Calculate NPV for each choice
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1. The internal rate of return (IR) is the interest rate that results in the present
value of cash outﬂows being equal to the present value of cash inﬂows from an
investment.
2. The higher the interest rate, the lower the present value. Example Karen's Boutique is considering purchasing a new sewing machine with a cost of$6.500,
salvage value of $1,500 and a useful life of three years. The machine is expected to save
operating expenses according to the following schedule. Karen’s cost of capital is 14
percent. Expected net cash inﬂows are: Year 1 $2,500 Year 2 2,200 Year 3 2.000
Required: a. What is the net present value of this investment? 4“, 1‘ M r"! “W
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 Spring '08
 Lui
 Accounting

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