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Chap07smOddNumber - Chapter 7 Some Alternative Investment Rules 7.1 a The payback period is the time that it takes for the cumulative undiscounted

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Chapter 7: Some Alternative Investment Rules 7.1 a. The payback period is the time that it takes for the cumulative undiscounted cash inflows to equal the initial investment. Project A : Cumulative Undiscounted Cash Flows Year 1 = $4,000 Cumulative Undiscounted Cash Flows Year 2 = $4,000 +$3,500 = $7,500 Payback period = 2 Project A has a payback period of two years. Project B : Cumulative Undiscounted Cash Flows Year 1 = $2,500 Cumulative Undiscounted Cash Flows Year 2 = $2,500+$1,200 = $3,700 Cumulative Undiscounted Cash Flows Year 3 = $2,500+$1,200+$3,000 = $6,700 Project B ’s cumulative undiscounted cash flows exceed the initial investment of $5,000 by the end of year 3. Many companies analyze the payback period in whole years. The payback period for project B is 3 years. Project B has a payback period of three years. Companies can calculate a more precise value using fractional years. To calculate the fractional payback period, find the fraction of year 3’s cash flows that is needed for the company to have cumulative undiscounted cash flows of $5,000. Divide the difference between the initial investment and the cumulative undiscounted cash flows as of year 2 by the undiscounted cash flow of year 3. Payback period = 2 + ($5,000 - $3,700) / $3,000 = 2.43 Since project A has a shorter payback period than project B has, the company should choose project A . b. Discount each project’s cash flows at 15 percent. Choose the project with the highest NPV. Project A = -$7,500 + $4,000 / (1.15) + $3,500 / (1.15) 2 + $1,500 / (1.15) 3 = -$388.96 Project B = -$5,000 + $2,500 / (1.15) + $1,200 / (1.15) 2 + $3,000 / (1.15) 3 = $53.83 The firm should choose Project B since it has a higher NPV than Project A has. Answers to End-of-Chapter Problems B-57
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7.3 a. The average accounting return is the average project earnings after taxes, divided by the average book value, or average net investment, of the machine during its life. The book value of the machine is the gross investment minus the accumulated depreciation. Average Book Value = (Book Value 0 + Book Value 1 + Book Value 2 + Book Value 3 + Book Value 4 + Book Value 5 ) / (Economic Life) = ($16,000 + $12,000 + $8,000 + $4,000 + $0) / (5 years) = $8,000 Average Project Earnings = $4,500 Divide the average project earnings by the average book value of the machine to calculate the average accounting return. Average Accounting Return = Average Project Earnings / Average Book Value = $4,500 / $8,000 = 0.5625 = 56.25% The average accounting return is 56.25%. b. 1. The average accounting return uses accounting data rather than net cash flows. 2. The average accounting return uses an arbitrary firm standard as the decision rule. The firm standard is arbitrary because it does not necessarily relate to a market rate of return. 3.
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This note was uploaded on 05/15/2011 for the course MBA o193 taught by Professor Na during the Spring '11 term at Indiana Wesleyan.

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Chap07smOddNumber - Chapter 7 Some Alternative Investment Rules 7.1 a The payback period is the time that it takes for the cumulative undiscounted

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