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Chapter 26: Q9RQ (page 1463)
How is payback calculated with unequal net cash inflows?
Answer
Payback Period = Initial Investment / Net Cash Flow per period
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Question: Using payback to make capital investment decisions Consider the following three projects. All three have an initial investment of \(800,000.
| Net Cash Inflows | ||||||
| Project L | Project M | Project N | ||||
Year | Annual | Accumulated | Annual | Accumulated | Annual | Accumulated |
1 | \) 100,000 | \( 100,000 | \) 200,000 | \( 200,000 | \) 400,000 | $ 400,000 |
2 | 100,000 | 200,000 | 250,000 | 450,000 | 400,000 | 800,000 |
3 | 100,000 | 300,000 | 350,000 | 800,000 | ||
4 | 100,000 | 400,000 | 400,000 | 1,200,000 | ||
5 | 100,000 | 500,000 | 500,000 | 1,700,000 | ||
6 | 100,000 | 600,000 | ||||
7 | 100,000 | 700,000 | ||||
8 | 100,000 | 800,000 | ||||
Requirements
Refer to Short Exercise S26-4. Continue to assume that the expansion has no residual value. What is the project’s IRR? Is the investment attractive? Why or why not?
Using payback, ARR, and NPV with unequal cash flows
Hughes Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machine at a cost of \(2,600,000. If refurbished, Hughes expects the machine to last another eight years and then have no residual value. Option 2 is to replace the machine at a cost of \)3,800,000. A new machine would last 10 years and have no residual value. Hughes expects the following net cash inflows from the two options:
Year | Refurbish current machine | Purchase new machine |
1 | \(1,760,000 | \)2,970,000 |
2 | 440,000 | 490,000 |
3 | 360,000 | 410,000 |
4 | 280,000 | 330,000 |
5 | 200,000 | 250,000 |
6 | 200,000 | 250,000 |
7 | 200,000 | 250,000 |
8 | 200,000 | 250,000 |
9 | 250,000 | |
10 | 250,000 | |
Total | \(3,640,000 | \)5,700,000 |
Hughes uses straight-line depreciation and requires an annual return of 10%.
Requirements
1. Compute the payback, the ARR, the NPV, and the profitability index of these two options.
2. Which option should Hughes choose? Why?
Question: Defining capital investment terms
Fill in each statement with the appropriate capital investment analysis method:
Payback, ARR, NPV, or IRR. Some statements may have more than one answer.
List some common cash outflows from capital investments.
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