Chapter 26: Q40CP (page 1476)

P26-40 Using payback, ARR, NPV, and IRR to make capital investment decisions
This problem continues the Piedmont Computer Company situation from Chapter 25. Piedmont Computer Company is considering purchasing two different types of servers. Server A will generate net cash inflows of $25,000 per year and have a zero residual value. Server A’s estimated useful life is three years, and it costs $45,000. Server B will generate net cash inflows of $25,000 in year 1, $15,000 in year 2, and $5,000 in year 3. Server B has a $5,000 residual value and an estimated useful life of three years. Server B also costs $45,000. Piedmont Computer Company’s required rate of return is 14%.
Requirements
1. Calculate payback, accounting rate of return, net present value, and internal rate of return for both server investments. Use Microsoft Excel to calculate NPV and IRR.
2. Assuming capital rationing applies, which server should Piedmont Computer Company invest in?

Short Answer

Expert verified

1. Capital budgeting figures:

Methods	Server A	Server B
Payback period	1.8 years	3 years
ARR	44.45%	6.67%
IRR	31%	6%
NPV	$13,040.80	-$4778.45

2.Capital rationing:Based on capital rationing, the business entity must select server A.

Step by step solution

Definition of Payback Period

A capital budgeting metric that determines the time period in which the investment will give back the cash invested or the investment/cash recovery period is known as the payback period.

Capital budgeting on both investments

Calculation of payback period:

1) Server A:

$\begin{matrix} P a y b a c k p e r i o d = \frac{I n i t i a l i n v e s t m e n t}{E x p e c t e d n e t a n n u a l c a s h f l o w} \\ = \frac{$ 45, 000}{$ 25, 000} \\ = 1.8 y e a r s \end{matrix}$

2) Server B:

The total cost of initial investment is recovered in year 3. Therefore, the payback period of server B is 3 years.

Working note:

Year	Cash inflow	Cumulative
1	$25,000	$25,000
2	$15,000	$40,000
3	$5,000	$45,000

Calculation of accounting rate of return:

1) Server A:

$\begin{matrix} A R R = \frac{A v e r a g e a n n u a l o p e r a t i n g i n c o m e}{A v e r a g e a m o u n t i n v e s t e d} \times 100 \\ = \frac{$ 10, 000}{\frac{$ 45, 000 + $ 0}{2}} \times 100 \\ = 44.45 % \end{matrix}$

Working note:

Particular	Amount $
Total net cash flows during the life of the project	$75,000
Less: Total depreciation during the life of the assetrole="math" localid="1656916821918" $($ 45, 000 - $ 0)$	$45,000
Total operating income during the operating life	$30,000
Asset operating life in years	3
Average annual operating incomerole="math" localid="1656916874860" $(\frac{$ 30, 000}{3})$	$10,000

Server B:

$\begin{matrix} A R R = \frac{A v e r a g e a n n u a l o p e r a t i n g i n c o m e}{A v e r a g e a m o u n t i n v e s t e d} \times 100 \\ = \frac{$ 1, 667}{\frac{$ 45, 000 + $ 5, 000}{2}} \times 100 \\ = 6.67 % \end{matrix}$

Working note:

Particular	Amount $
Total net cash flows during the life of the project	$45,000
Less: Total depreciation during the life of the asset $($ 45, 000 - $ 5, 000)$	$40,000
Total operating income during the operating life	$5,000
Asset operating life in years	3
Average annual operating income $(\frac{$ 5, 000}{3})$	$1,667

Calculation of NPV and IRR:

Project	Server A	Server B
Useful life	3	3
Discounting rate	0.14	0.14
Initial investment	-45,000	-45,000
Year
1	25,000	25,000
2	25,000	15,000
3	25,000	10,000	(5,000+5,000)
Total	75,000	50,000

Output
NPV	$13,040.80	($4,778.45)
IRR	31%	6%

Excel formula for NPV: =NPV(Discount rate, Cash flow from 1^st year to 10^th year)+Initial investment

Excel formula for IRR: =IRR(All cash flows from year 1^st year to 10^th year including initial investment)

Using capital rationing

Server	Total present value of cash flows	/	Initial investment	=	Profitability index
A	75,000	/	45,000	=	1.67
B	50,000	/	45,000	=	1.11

Unlock Step-by-Step Solutions & Ace Your Exams!

Full Textbook Solutions
Get detailed explanations and key concepts
Unlimited Al creation
Al flashcards, explanations, exams and more...
Ads-free access
To over 500 millions flashcards
Money-back guarantee
We refund you if you fail your exam.

Start your free trial

Over 30 million students worldwide already upgrade their learning with Vaia!

Recommended explanations on Business Studies Textbooks

View all explanations

What do you think about this solution?

We value your feedback to improve our textbook solutions.

	Equipment A	Equipment B	Equipment C
Present value of net cash inflows	\(1,647,351	\)1,969,888	\(2,064,830
Initial investment	(1,484,100)	(1,641,573)	(1,764,812)
NPV	\)163,251	\(328,315	\)300,018

Short Answer

Step by step solution

Definition of Payback Period

Capital budgeting on both investments

Using capital rationing

One App. One Place for Learning.

Most popular questions from this chapter

Recommended explanations on Business Studies Textbooks

Organizational Communication

Corporate Finance

Intermediate Accounting

Business Development

Managers

Managerial Economics

Study anywhere. Anytime. Across all devices.