Suppose that a company is considering two different and mutually exclusive proje
ID: 2499930 • Letter: S
Question
Suppose that a company is considering two different and mutually exclusive projects (A and B), where both have a five-year life and require an investment of 58^,000. The cash flow patterns for each project are given below. Project A: Even cash flows of $28,000 per year. Project B: $48.000.$4O.OOO. $36,000. $20.000. and $12.000. Required a ululate the payback period for Project A (round to one decimal place): Payback period = years years and is - Select your answer - than payback for Project A; thus Project B is - Select your answer - and has - Select your answer - | impact on liquidity. Calculate the payback period for Project B by completing the following table: Now assume that a third project, Project C becomes available with the same investment outlay and the following annual cash flows (projects, A, B, and C are mutually exclusive): Project C: S66.000. 520,000, 550,000, S50.000. and 550,000 Calculate the payback for Project C (round to one decimal place):Payback period = years more for the years beyond the payback period than Project B. Second, Project C returns S that Project C returns in the first year could be put to productive use, such as investing in another project. The payback period thus b. Project C has the same payback as Project B but should be preferred over Project B for two reasons. First, Project C provides 5 in the first year, while Project B returns only 5 . The extra 5- Select your answer - I the time value of money.Explanation / Answer
1. Even cash flows:
Payback period = Original investment/Annual cash flow
= $84,000 / $28,000
= 3.0 years
2. Uneven cash flows:
Unrecovered Investment Annual Time Needed
Year (beginning of year) Cash Flow for Payback
1.................... $84,000 $48,000 1.0 year
2.................... 36,000 40,000 0.9 year*
*At the beginning of the year, an additional $36,000 is needed to recover the investment. Since a net cash flow of $40,000 is expected, only 0.9 year ($36,000/$40,000) is needed to recover the remaining $36,000, assuming a uniform cash flow throughout the year.
Project B has a shorter payback period and thus seems less risky and would have less impact on liquidity.
3. Yearly depreciation expense: ($84,000 – $0)/5 = $16,800
Year 1 net income = $66,000 – $16,800 = $49,200
Year 2 net income = $20,000 – $16,800 = $3,200
Year 3 net income = $50,000 – $16,800 = $33,200
Year 4 net income = $50,000 – $16,800 = $33,200
Year 5 net income = $50,000 – $16,800 = $33,200
a. Total net income (five years) = $152,000
Average net income = $152,000/5 = $30,400
Payback period = $84,000/$30,400 = 2.76 years
b . Average net income = $152,000/5 = $30,400. Thus, Payback period= $84,000/$30,400 = 2.76 years, which is less than the payback of the echocardiogram. The second project has a lower accounting rate of return; thus, the metric would say to invest in the echocardiogram. However, in reality, the second project would be preferred even though it provides a lower payback and less total cash because it returns larger amounts of cash sooner than the first project. It is possible that the time value of money may shift the choice to the second project.
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