PROBLEM 2-CAPITAL BUDGETING (36 points) Henley Company is considering a capital

Question

PROBLEM 2-CAPITAL BUDGETING (36 points) Henley Company is considering a capital investment of $800,000 expected to have a useful life of 10 years with no salvage vaiue the straight-line method. During the life of the investment, ann requires are expected to be $52,500 and $112,500, respectively. H return, or a payback period of 6 years. considering a capital investment of $600,0o0 in newi computed by equipment. It is e life of the investment, net income and net cash flows 15% rate of nley requires either a Instructions: Compute the (a) of resent value of total project, and (d) internal rate of return. hether the project should be accepted nting rate of return, (b) cash payback period, (c) net Show ali computations. State echniques. or rejected for each of the four capital budgeting Present Value of a Series of Future Payments 13% 14% 15% Period! 1% 9% 10% 11% 12% 2% 3% 5% 6% 7% 109991 0.5004 .9709 2 1.9704 19416 1.9 | 1 34 0001 | 1 267302.6243 2571 25313 24869 24437 24018 2.3612 2.3216 2.283 35460 3451 382 3312132297 3.169 31024 3.0373 25745 29437 2.85 8334 180e 3 29410 2889 28286 2.7751 2.7 4.8534 4.7135 6.7865 5.80747 51 757 4Ta3858278 4850 5 4208 4154 39rs 388 6 5.7955 5,6014 6412 52421 5,0757 49173 4765 46229 4.4859 4.3653 1750. 362 67282 64720 62303 6.0021 6 6.5824 53893 5.2064 50330 48681224853 45638 44226 4.28834 6.7864 64632 51461 49676 4.7988 46389 55370 63282 5.1317 4.9464 7466 6517 7.3255 7.0197 9 8.5660 81622 7.7861 7.4353 7.1078 6.8017 6.5152 62469 59952 5.7590 5.4262 52161 10 94713 8.9626 85302 81109 7.7217 7,3601 7.0236 67101 64177 646 5.8882 5.6502 Accounting Rate of Return = Cash Payback Period Net Present Value ternal Rate of Return hould the project be accepted, explain why Yes, or No?

Explanation / Answer

Initial investment = $600,000

Annual net income = $52,500

Annual net cash inflow = $112,500

Rate of return required = 15%

(i) Accounting rate of return = Annual net income/Initial investment

= 52,500/600,000

= 8.75%

(ii) Payback period refers to the time in which initial investment in the project is recovered.
Payback period = A + B/C
where,
A = years full recovery
B = unrecovered cost at the begining of the last year
C = cash flows in the following year

Annual cash inflow = $112,500

Hence, cash inflows in 5 years = 112,500 x 5

= $562,500

Hence, shortage to be recovered in year 6 = 600,000 - 562,500

= $37,500

Cash payback period = 5 + 37,500/112,500

= 5 + 0.33

= 5.33 years

(iii) Net present value = Present value of cash inflows - Present value of cash outflows

= 112,500 x PVAF(15%, 10) - 600,000

= 112,500 x 5.019 - 600,000

= 564,615 - 600,000

= -$35,385 (approx)

(iv) Since at 15%, NPV is negative, hence we must calculate NPV at a lower rate.

Let us calculate NPV at 13%.

Net present value at 13% = Present value of cash inflows - Present value of cash outflows

= 112,500 x PVAF(13%, 10) - 600,000

= 112,500 x 5.426 - 600,000

= 610,425 - 600,000

= $10,425 (approx)

At 13%, NPV is positive, hence the IRR of the project must lie between 13% to 15%. Exact IRR can be calculated as under:
IRR = Lower rate + {NPV at lower rate/(NPV at lower rate - NPV at higher rate)} x (Higher rate - lower rate)
= 13% + {10,425/(10,425 + 35,385)} x (15% - 13%)
= 13% + (10,425/45,810) x 2
= 13% + 0.45%
= 13.45%
Hence, IRR of the project is 13.45%(Approx.)

(v) Since Henley requires either rate of return of 15% or a cash payback period of 6 years, hence the project can be selected on the basis of payback period since payback period is 5.33 years, which is less than the required payback period of 6 years.

Kindly give a positive rating if you are satisfied with the answer. Feel free to ask if you have any doubt. Thanks.

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