Chapter 26: Q10RQ (page 1463)
What is the decision rule for payback?
Answer
The general rule is that investments with shorter payback periods are observed as more appropriate and preferable.
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What is the accounting rate of return?
How is the present value of an annuity determined?
What is the internal rate of return?
Mountain Manufacturing is considering the following capital investment proposals. Mountain’s requirement criteria include a maximum payback period of five years and a required rate of return of 12.5%. Determine if each investment is acceptable or should be rejected (ignore qualitative factors). Rank the acceptable investments in order from most desirable to least desirable
Project | A | B | C | D | E |
Payback | 3.15 years | 4.20 years | 2.00 years | 3.25 years | 5.00 years |
NPV | \(10,250 | \)42,226 | (\(10,874) | \)36,251 | $0 |
IRR | 13.0% | 14.2% | 8.5% | 14.0% | 12.5% |
Profitability index | 1.54 | 1.92 | 0.75 | 2.86 | 1.00 |
Water City is considering purchasing a water park in Omaha, Nebraska, for \(1,920,000. The new facility will generate annual net cash inflows of \)472,000 for eight years. Engineers estimate that the facility will remain useful for eight years and have no residual value. The company uses straight-line depreciation, and its stockholders demand an annual return of 12% on investments of this nature.
Requirements
1. Compute the payback, the ARR, the NPV, the IRR, and the profitability index of this investment.
2. Recommend whether the company should invest in this project.
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