A company has $40 million to invest in any or all of the four capital investment projects, which have cash flows as shown below.
Year of Cash Flow
Project Type of cash flow Yr 0 Yr 1 Yr 2 Yr 3
A Investment ($10,000)
Operating expenses $11,000
B Investment ($10,000)
Revenue $15,000 $17,000
Operating expenses $5,833 $7,833
C Investment ($10,000)
Revenue $10,000 $11,000 $30,000
Operating expenses $5,555 $4,889 $15,555
D Investment ($10,000)
Revenue $30,000 $10,000 $5,000
Operating expenses $15,555 $5,555 $2,222
All revenues and operating expenses can be considered cash items.
Each project is of equal risk. The investment will be depreciated to zero on a straight line basis for tax purposes. The company's marginal corporate tax rate on taxable income is 40%.
None of the projects will have any salvage value at the end of their lives. For purposes of analysis, it should be assumed that all cash flows occurs at the end of the year.
A: Rank the four projects according to the following four commonly used capital budgeting criteria:
1. Payback period.
2. Accounting return on investment. For purposes of this exercise, the accounting return on investment should be defined as follows:
Average annual after-tax profits / (Required investment/2)
3. Internal rate of return.
4. Net present value, assuming alternately a 10% discount rate and a 35% discount rate.
B: Why do the rankings differ? What does each technique measure and what assumptions does it make?
C: If the projects are independent of each other, which should be accepted? If they are mutually exclusive (i.e., one and only one can be accepted), which one is best?
The solution examines capital investment projects. The cash flow of these projects are examined.