Question

(Click the icon to view Present Value of (Click the icon to view Future Value of * Requirements X of he pl ne de 1. Compute the payback, the ARR, the NPV, and the profitability index of these two plans. 2. What are the strengths and weaknesses of these capital budgeting methods? 3. Which expansion plan should Hill Company choose? Why? 4. Estimate Plan A's IRR. How does the IRR compare with the company's required rate of return? Print Done and then click Check Answer Clear All

Answer 1

ANSWER:

Req. 1

Payback period	=	Initial investment
Expected annual net cash inflow
Plan A	=	$8700,000
$1550000
	=	5.6 years
Plan B	=	$8,340,000
$990000
	=	8.42 years

Accounting rate of return	=	Average annual operating income from asset
Initial investment
		Average annual net                   cash inflow from asset − Annual depreciation expense on asset
		Initial investment
Plan A	=	$1550000 − $870000 a
$8,700,000
	=	$680000
	$8,700,000
	=	7.8%
Plan B	=	$990000 − $714000 b
$8,340,000
	=	$276000
	$8,340,000
	=	3.31%

__________

^a  Annual depreciation = $8,700,000 / 10= $870000

^b  Annual depreciation = ($8,340,000 − $1,200,000) / 10 = $714000

	PV factor at i = 10%, n = 10	Net Cash Inflow	Total Present Value
Plan A:
Present value of annuity of
equal annual net cash
inflows for 10 years at 10%	6.145 c ×  $1550000 per year	$ 9524750
Less: Initial Investment		(8,700,000)
Net present value of Plan A		$  824750
Plan B:
Present value of annuity of
equal annual net cash
inflows for 9 years at 10%	6.145c ×  $990,000 per year	$  6083550
Present value of residual value (lump sum, not annuity)	0.386 d × $1,200,000	463200
Less: Initial investment		(8,340,000)
Net present value of Plan B		$    (1793250)

^c  Present Value of Annuity of $1 (n = 10, i = 10%)

^d Present Value of $1 (n = 10, i = 10%)

Net present value is based on cash flows, can be used to assess profitability, and takes into account the time value of money. It has none of the weaknesses of the other two models.

Payback method is easy to understand, is based on cash flows, and highlights risks. However, payback ignores profitability and the time value of money.

Accounting rate of return can be used to assess profitability, but it ignores the time value of money.

Req. 2

Recommendation: Invest in Plan A. It has the higher net present value. It also has a shorter payback period and a higher accounting rate of return.

Req. 3

The IRR for Project A is computed as follows:

Initial investment	=	Annuity PV factor (i = ?, n = ?)
Amount of each annual net cash inflow
	$8,700,000		=	Annuity PV factor (i = ?, n = 10)
	$1,550,000
5.613	=	Annuity PV factor (i = ?, n = 10)

The IRR (internal rate of return) of Plan A is between 12% and 14%.

This rate exceeds the company's hurdle rate of 10%.