Doug\'s Custom Construction Company is considering three new projects, each requ

Question

Doug's Custom Construction Company is considering three new projects, each requiring an equipment investment of $26,400. Each project will last for 3 years and produce the following net annual cash flows. Year AA 1$8,400 $12,000 $15,600 2 10,800 12,000 14,400 3 14,400 12,000 13,200 Total $33,600 $36,000 $43,200 The equipment's salvage value is zero, and Doug uses straight-line depreciation, Doug will not accept any project with a cash payback period over 2 years. Doug's required rate of return is 12%. Click here to view tabe

Explanation / Answer

(a) Cash payback period is the time upto which initial cost is recovered back. Project AA: Project BB: Project CC: Year Cash flows Cumulatve cash flows Cash flows Cumulatve cash flows Cash flows Cumulatve cash flows 1 $              8,400 $          8,400 $        12,000 $             12,000 $            15,600 $             15,600 2 $            10,800 $        19,200 $        12,000 $             24,000 $            14,400 $             30,000 3 $            14,400 $        33,600 $        12,000 $             36,000 $            13,200 $             43,200 Payback Period = 2+(26400-19200)/14400 = 2+(26400-24000)/12000 = 1+(26400-15600)/14400 =                 2.50 =                      2.20 = 1.75 Thus, AA                     2.50 Years BB                     2.20 Years CC 1.75 Years Most Desirable Project: Project CC Project CC is within the limit of cash payback period of 2 years.So, Project CC is desirable project. Least desirable project: Project AA Project AA has highest cash payback period.However this is also within the limit of 3 years life of investment. So, all the three projects are acceptable.But Project AA is least desirable Project. (b) Project AA: Project BB: Project CC: Year Cash flows Discount factor Present Value Cash flows Discount factor Present Value Cash flows Discount factor Present Value 1 $              8,400          0.89286 $                  7,500 $        12,000               0.89286 $               10,714 $            15,600               0.89286 $            13,929 2 $            10,800          0.79719 $                  8,610 $        12,000               0.79719 $                  9,566 $            14,400               0.79719 $            11,480 3 $            14,400          0.71178 $               10,250 $        12,000               0.71178 $                  8,541 $            13,200               0.71178 $               9,395 $               26,359 $               28,822 $            34,804 Net Present Value AA $            26,359 BB $            28,822 CC $            34,804 Most Desirable Project: Project CC Least desirable project: Project AA

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