X-treme Vitamin Company is considering two investments, both of which cost \(10,000. The cash flows are as follows:

Year

Project A

Project B

1

\)12,000

$10,000

2

8,000

6,000

3

6,000

16,000

a. Which of the two projects should be chosen based on the payback method?

b. Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent.

c. Should a firm normally have more confidence in answer a or answer b?

Short Answer

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Answer

  1. Payback method:

Project A: 0.83 years.

Project B: 1 year.

  1. Net present value:

Project A: $12,022

Project B: $16,062

The business entity will have more confidence in answer b.

Step by step solution

01

Definition of Capital Budgeting

Capital budgeting can be defined as the process by which the investors assess the different available investment options. It includes methods such as the payback method, Net present value, and IRR.

02

Payback method

Project A:

Paybackperiod=Periodbeforefullrecovery+AmountrecoveredinlastperiodCashflowinlastrecoveryperiod=0+$10,000$12,000=0+0.83=0.83years

Project B:

Paybackperiod=Periodbeforefullrecovery+AmountrecoveredinlastperiodCashflowinlastrecoveryperiod=0+$10,000$12,000=0+1=1years

03

Net present value method

Project A:

Year

Cash flow

PVIF @ 10%

Present value

1

$12,000

0.909

$10,908

2

$8,000

0.826

$6,608

3

$6,000

0.751

$4,506

Total present value of cash inflows
$22,022
Less: initial investment
(10,000)
Net present value of cash inflows
12,022

Project B:

Year

Cash flow

PVIF @ 10%11+rn

Present value

1

$10,000

0.909

$9,090

2

$6,000

0.826

$4,956

3

$16,000

0.751

$12,016

Total present value of cash inflows
$26,062
Less: initial investment
(10,000)
Net present value of cash inflows
16,062

Using net present value figures, the business entity must select project B because it has a higher net present value.

04

Appropriate method

The firm will have more confidence in answer to part (b) because it considers the time value of money.

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