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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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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.

$2.19
See Also This Related BrainMass Solution

Capital budgeting techniques to maximize share wealth

The objective of a firm is to maximize shareholder wealth. The Net Present Value (NPV) method is one of the useful methods that help financial managers to maximize shareholders' wealth.

Suppose the company that you selected for the Module 1 SLP is considering a new project that will have an initial cash outflow of $125,000,000. The project is expected to have the following cash inflows:

Year Cash Flow ($)

1 2,000,000

2 3,500,000

3 13,500,000

4 89,750,000

5 115,000,000

6 120,000,000

If the project's cost of capital (discount rate) is 12.5%, what is the project's NPV? Should the project be accepted? Why or why not?

You may use the following steps to calculate NPV:

1. Calculate present value (PV) of cash inflow (CF)

PV of CF = CF1 / (1+r)^1 + CF2 / (1+r)^2 + CF3 / (1+r)^3 + CF4 / (1+r)^4 + CF5 / (1+r)^5 + CF6 / (1+r)^6

Where the CFs are the cash flows and r = the project's discount rate.

2. Calculate NPV

NPV = Total PV of CF - Initial cash outflow

or -Initial cash outflow + Total PV of CF

r = Discount rate (12.5%)

If you do not know how to use Excel or a financial calculator for these calculations, please use the present value tables. Brealey, R.A., Myers, S.C., & Allen, F. (2005). Principles of corporate finance, 8th Edition. McGraw−Hill. Retrieved June 2014 from http://jcooney.ba.ttu.edu/fin3322/Brealey%20Files/Appendix%20A%20-%20Present%20Value%20Tables.pdf (Please use Table 1)

Also, consider reviewing http://www.tvmcalcs.com for financial calculator tutorials.

Besides NPV, there are other capital budgeting methodologies including the regular payback period, discounted payback period, profitability index (PI), internal rate of return (IRR), and modified internal rate of return (MIRR). These methodologies don't necessarily give the same accept/reject decisions as NPV.

If the firm has a requirement that projects are paid back within 3 years, would the project be accepted based off the regular payback period? Why or why not? Would the project be accepted based off the discounted payback period? Why or why not?

What is the project's internal rate of return (IRR)? Based off IRR, should the project be accepted? Why or why not? Recall the project's cost of capital is 12.5%. What is the project's modified internal rate of return (MIRR)? Based off MIRR, should the project be accepted? Why or why not?

What are the advantages/disadvantages of NPV, regular payback, discounted payback, PI, IRR, and MIRR? Present these advantages/disadvantages in a table.

•Describe the purpose of the report and provide a conclusion. An introduction and a conclusion are important because many busy individuals in the business environment may only read the first and the last paragraph. If those paragraphs are not interesting, they never read the body of the paper.
•Answer the SLP Assignment question(s) clearly and provide necessary details.
•Write clearly and correctly—that is, no poor sentence structure, no spelling and grammar mistakes, and no run-on sentences.
•Provide citations to support your argument and references on a separate page. (All the sources that you listed in the references section must be cited in the paper.) Use APA format to provide citations and references.
•Type and double-space the paper.
•Whenever appropriate, please use Excel to show supporting computations in an appendix, present financial information in tables, and use the data computed to answer follow-up questions. In finance, in addition to being able to write well, it's important to present information in a professional manner and to analyze financial information. This is part of the assignment expectations and will be considered for grading purposes.

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