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    Capital Rationing Using the Payback and Net Present Value Methods

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    Unifying Concepts: Capital Rationing Using the Payback and Net Present Value Methods
    Dino Corporation is trying to decide which of five investment opportunities it should undertake.
    The company's cost of capital is 16%. Owing to a cash shortage, the company has a policy
    that it will not undertake any investment unless it has a payback period of less than three
    years. The company is unwilling to undertake more than two investment projects. The following
    data apply to the alternatives:
    Investment Initial Cost Expected Returns
    A $100,000 $30,000 per year for 5 years
    B 50,000 25,000 per year for 6 years
    C 30,000 8,000 per year for 10 years
    D 20,000 7,000 per year for 6 years
    E 10,000 3,500 per year for 3 years
    Required:
    1. Using the payback method, screen out any investment project that fails to meet the company's
    payback period requirement.
    2. Using the net present value method, determine which of the remaining projects the company
    should undertake, keeping in mind the capital rationing constraint.
    3. Interpretive Question: What advantages do you see in using the payback method together
    with other capital budgeting methods?

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    https://brainmass.com/economics/personal-finance-savings/capital-rationing-using-the-payback-and-net-present-value-methods-123201

    Solution Preview

    Please see the attached file.

    Part 1:
    Payback period criteria: Accept the project if payback period is less than 3 years.

    Payback period = Initial investment / annual expected return
    Project Payback period Decision
    A =$100,000/$30,000=3.33 Greater than 3 years. Reject
    B =50,000/25,000=2.0 Less than 3 years. Accept
    C =30,000/8,000 = 3.75 Greater than 3 years. Reject
    D = ...

    Solution Summary

    The payback method is highlighted.

    $2.49

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