Special Decisions and Capital Budgeting: Capital Budgeting Capital budgeting P25

Question

Special Decisions and Capital Budgeting: Capital Budgeting

Capital budgeting P25-39B Playtime, Inc.is considering purchasing an amusement park in El Paso, Texas, for S2,000,000. The new facility will generate annual net cash inflows of S520,000 for eight years. Engineers estimate that the facility will remain useful for eight years and have a residual value of $200,000 The company uses straight-line depreciation, and its stockholders demand an annual return of 12% on investments of this nature. Requiremerts 1. Compute the payback period (p. 1267), the accounting rate of return (p. 1269), and the net present value (pp. 1270-1273) of this investment 2. Make a recommendation whether the company should invest in this project. (p. 1262)

Explanation / Answer

1. Payback Period =   Initial Investment / Cash Inflow per Period

= 2,000,000 / 520,000 = 3.8461 = 3 years 10 months approx

2. Accounting Rate of Return = Average Accounting Profit / Average Investment

Annual Depreciation = (Initial Investment Scrap Value) ÷ Useful Life in Years

Annual Depreciation = ( 2,000,000 - 200,000 ) / 8 = 225,000

Average Accounting Income = 520,000 - 225,000 = 295,000

Accounting Rate of Return = 295,000 / 2,000,000 = 0.1475 or 14.75%

3. Net Present Value

4. Company should invest in this project as its net present value of investment and cash flow generated is positive

YEAR PARTICULAR AMOUNT DIS @ 12% DIS CASH FLOW 0 Initial Investment                   -20,00,000 1                         -20,00,000 1 Annual Cash Flow                       5,20,000 0.8929                             4,64,286 2 Annual Cash Flow                       5,20,000 0.7972                             4,14,541 3 Annual Cash Flow                       5,20,000 0.7118                             3,70,126 4 Annual Cash Flow                       5,20,000 0.6355                             3,30,469 5 Annual Cash Flow                       5,20,000 0.5674                             2,95,062 6 Annual Cash Flow                       5,20,000 0.5066                             2,63,448 7 Annual Cash Flow                       5,20,000 0.4523                             2,35,222 8 Annual Cash Flow                       5,20,000 0.4039                             2,10,019 8 Scrap Value                       2,00,000 0.4039                                 80,777 NET PRESENT VALUE                             6,63,949

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