The Lavender Toy Company has been a family run business for the last 25 years. I
ID: 2769099 • Letter: T
Question
The Lavender Toy Company has been a family run business for the last 25 years. It is well recognized in the state of Michigan for selling educational related toys specifically for children, ages 4 through 8. Once a year, Lavender Toy goes through an extensive analysis as to which new toy they should promote for the upcoming year. They only have room to manufacture one new toy because they will drop the poorest selling toy, automatically, from their product line. Colleen, Kasey, Elvira June, Market Experts employed by Lavender Toy, have prepared the following information regarding their suggestions as to which toy should be promoted during the upcoming year.
Potential Toys to be considered
Betsy Blocks
Knute Numbers
Donna Dollie
Initial Investment
$90,000
$108,000
$78,950
Annual Cash Flows
$36,000
$42,000
N/A
Number of Years flow expected to continue
5
6
N/A
Salvage Value
None
$1500
None
Lump Sum Payment
None
None
$128,000 at end of Year 7
Corporate Rate of Return
10 per cent
10 per cent
10 per cent
Current rate of interest of CDs
4 per cent
4 per cent
4 per cent
Required:
Using your new 3 tools for capital budgeting, rank these investment opportunities: 1 = highest, 2 = middle, 3 = lowest. Show all computations in good form.
Support your rankings with sound capital budgeting analysis.
Potential Toys to be considered
Betsy Blocks
Knute Numbers
Donna Dollie
Initial Investment
$90,000
$108,000
$78,950
Annual Cash Flows
$36,000
$42,000
N/A
Number of Years flow expected to continue
5
6
N/A
Salvage Value
None
$1500
None
Lump Sum Payment
None
None
$128,000 at end of Year 7
Corporate Rate of Return
10 per cent
10 per cent
10 per cent
Current rate of interest of CDs
4 per cent
4 per cent
4 per cent
Explanation / Answer
Introduction: The most valuable aim of capital budgeting is to rank investment proposals. To choose the most valuable investment option, several methods are commonly used:
Computation For Ranking :
1. NPV method:
Based on NPV, Investment in Knute Numbers is the better investment opportunity becasue it have high NPV compare to other two opportunities.
2. Profitability Index (PI) :
It is a useful tool for ranking projects, because it allows you to quantify the amount of value created per unit of investment. The ratio is calculated as follows:
Profitability index = PV of future cash flows / Initial investment
From the above table we know the Pv of future cash flows
Therefore, Betsy Blocks, PI = 136,440 / 90,000 = 1.516
Knute Numbers, PI = 183,706 / 108,000 = 1.7
Donna Dollie, PI = 65,660 / 78,950 = 0.83
Based on above 3 figures 1.7 is the higher figure, Therefore Knute Numbers ranks 1st and Betsy Blocks ranks 2nd place and Donna Dollie ranks 3rd.
3.Payback Period Method:
Formula for payback period, Payback Period =Initial Investment / Cash Inflow per Period
Therefore, Betsy Blocks, Payback period = 90,000 / 36,000 = 2.5
For Knute Numbers, Payback period is calculated differently because the cash flows are different for each period.
Payback period = A+ B/C
Here, A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A
now, let us find the cumulative figures: for Knute Numbers
Payback period = 2 + 24,000 / 42,000
=2 + 0.57 = 2.57 is the payback period for Knute Numbers
and for Donna Dollie, no need to calculate any payback period because the cash flow is their only in year 7 as a lumpsum amount . here payback period = 7years.
Based on payback period Betsy Blocks, Payback period = 2.5, Ranks 1st place
2.57 is the payback period for Knute Number, ranks 2nd place
Donna Dollie, payback period = 7years, ranks 3rd place.
options Cash flow Present value annuity factor @10% present value of cash flows Net present value = present value of cash flows - initial investment Ranking Betsy Blocks 36,000 for 5 years = 3.79 136,440 136,440-90,000 = 46,440 2 Knute Numbers 42,000 + 1,500in year 6 for 6 years = 4.354 and in year 6 its 0.564 182,860+846 =183,706 183,706-108,000 = 75,000 1 Donna Dollie 128,000 in year 7 only for 7th year =0.513 65,660 65,660 - 78,950 = -13,290 3Related Questions
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