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Capital Budgeting Techniques



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Chapter 9 Capital Budgeting Techniques Solutions to Problems Note to instructor In most problems involving the internal rate of return calculation a financial calculator has been used P9 1 LG 2 Payback Period Basic a 42 000 7 000 6 years b The company should accept the project since 6 8 P9 2 LG 2 Payback Comparisons Intermediate a Machine 1 14 000 3 000 4 years 8 months Machine 2 21 000 4 000 5 years 3 months b Only Machine 1 has a payback faster than 5 years and is acceptable c The firm will accept the first machine because the payback period of 4 years 8 months is less than the 5 year maximum payback required by Nova Products d Machine 2 has returns which last 20 years while Machine 1 has only seven years of returns Payback cannot consider this difference it ignores all cash inflows beyond the payback period 222 P9 3 Part 3 Long Term Investment Decisions LG 2 Choosing Between Two Projects with Acceptable Payback Periods Intermediate a Year Project A Cash Investment Inflows Balance 0 Year 100 000 0 Project B Cash Investment Inflows Balance 100 000 1 10 000 90 000 1 40 000 60 000 2 20 000 70 000 2 30 000 30 000 3 30 000 40 000 3 20 000 10 000 4 40 000 0 4 10 000 0 5 20 000 5 20 000 Both project A and project B have payback periods of exactly 4 years b Based on the minimum payback acceptance criteria of 4 years set by John Shell both projects should be accepted However since they are mutually exclusive projects John should accept project B c Project B is preferred over A because the larger cash flows are in the early years of the project The quicker cash inflows occur the greater their value P9 4 LG 3 NPV Basic PVn PMT PVIFA14 20 yrs NPV PVn Initial investment a PVn 2 000 6 623 PVn 13 246 NPV 13 246 10 000 NPV 3 246 Calculator solution 3 246 26 Accept b PVn 3 000 6 623 PVn 19 869 NPV 19 869 25 000 NPV 5 131 Calculator solution 5 130 61 Reject c PVn 5 000 6 623 PVn 33 115 NPV 33 115 30 000 NPV 3 115 Calculator solution 3 115 65 Accept Chapter 9 P9 5 LG 3 NPV for



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