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Comparison of capital budgeting techniques

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The department is considering the purchase of a new, more efficient pool heater for its swimming pool at a cost of \$15000. It should save \$3000 in cash operating costs per year. The estimated useful life is 8 years and zero disposal value. Ignore taxes.
1. What is the payback time?
2. Compute the NPV if the minimum rate of return desired is 8%. should department buy the heater? Why?
3. Using the ARR model, compute the rate of return on the initial investment.

SOLUTION This solution is FREE courtesy of BrainMass!

1. What is the payback time?

Payback is the number of years it will take for the cash flows to recover the initial investments. See Excel attached for analysis.

2. Compute the NPV if the minimum rate of return desired is 8%. should department buy the heater? Why?

Yes, you should buy the heater. The returns, discount to the present at 8%, are greater than the initial cost. Said another way, the returns offer a return higher than 8% on the initial investment. See Excel attached for analysis.

NPV is for the project. For all the future cashflows expected, over the full eight years, discounted back to the present, you are earning more than the initial cost by the amount of the NPV. It is not a "per year" amount. It is for the full life of the project. What is the annual return? You would need to compute the IRR. To illustrate, I added IRR to the analysis showing just under a 12% return per year.

3. Using the ARR model, compute the rate of return on the initial investment.

The accounting rate of return for the project is 160%. Now that is NOT 160% "per year." That is 160% over the entire project life of 8 years. You would need to compute the IRR or MIRR to get an annualized average rate of return to know what the annual return per year, on average, for the project. See Excel attached for analysis.

http://accountingexplained.com/managerial/capital-budgeting/arr
http://accountingexplained.com/managerial/capital-budgeting/payback-period
http://accountingexplained.com/managerial/capital-budgeting/npv

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Your tutorial is 165 words plus three references and an analysis in Excel which is a template to use for future problems.

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