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Capital Rationing Using the Payback and Net Present Value Methods

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
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.