Capital Budgeting
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Strident Marks is considering purchasing new manufacturing equipment that costs $1,300,000 and is expected to improve cash flows by $500,000 in year 1, $350,000 in year 2, $475,000 in year 3, $450,000 in year 4, and $300,000 in year 5. Calculate key financial metrics for this capital budgeting project. A 14% rate of return and a payback period of less than five years are required for this project. These key metrics must include (1)payback period, (2) net present value, and (3) internal rate of return. (Use 6% as the weighted average cost of capital). In a memo to the CFO, discuss the metrics and make a recommendation whether to accept or reject the project. Please include spreadsheet of figures.
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Solution Summary
The solution explains how to calculate payback period, net present value, and internal rate of return for a project.
Solution Preview
The calculation are in the excel file.
1. Payback Period - In Payback period we get the time it takes to get back the initial investment from the project cash inflows. In this method, no discounting is used and the cash flows are simply added till we get back the initial investment. While not discounting is a drawback, this method is a measure of liquidity, since projects which have lower payback are more liquid. We get back the initial investment faster. Under this method, lower period are better. Payback method is not used in making accept reject decisions since it does not take into account the time value of money. Here the initial investment is 1,300,000. In years 1 and 2 we recover $850,000 and so $450,000 is left. This is recovered in year 3. In year 3, we get a total of 475,000, so the time taken to recover 450,000 is 450,000/475,000=0.95 years. The total payback period is 2.95 years.
2. Net ...
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