PART 3: CAPITAL BUDGETING
Asset A Asset B
Year Cash flow Depreciation Cash flow Depreciation
0 –$200,000 – –$180,000 –
1 $70,000 $40,000 $80,000 $36,000
2 80,000 40,000 90,000 36,000
3 90,000 40,000 30,000 36,000
4 90,000 40,000 40,000 36,000
5 100,000 40,000 40,000 36,000a Calculate the payback period for each
asset, assess its acceptability and indicate
which asset is best, using the payback
period.
b Calculate the discounted payback for
each asset, assess its acceptability and
indicate which asset is best, using the
discounted payback.
c Assuming that each year’s net income
equals cash flow minus depreciation,calculate the accounting rate of return
from each asset, assess its acceptability
and indicate which asset is best, using
the accounting rate of return.
d Compare and contrast your findings
in parts (a), (b) and (c). Which asset
would you recommend to Nader,
assuming that they are mutually
exclusive? Why?ST9-2 JK Products Pty Ltd is considering investing in either of two competing projects that will
allow the company to eliminate a production bottleneck and meet the growing demand for
its products. The company’s engineering department narrowed the alternatives down to two:
Status Quo (SQ) and High Tech (HT). Working with the accounting and finance personnel,
the company’s CFO developed the following estimates of the cash flows for SQ and HT over
the relevant six-year time horizon. The company has an 11% required return, and views these
projects as equally risky.Project SQ Project HT
Year Cash flows
0 –$670,000 –$940,000
1 $250,000 $170,000
2 200,000 180,000
3 170,000 200,000
4 150,000 250,000(^5) 130,000 300,000
(^6) 130,000 550,000
a Calculate the net present value (NPV)
of each project, assess its acceptability,
and indicate which project is best, using
NPV.
b Calculate the internal rate of return
(IRR) of each project, assess its
acceptability and indicate which
project is best, using IRR.
c Calculate the profitability index (PI) of
each project, assess its acceptability and
indicate which project is best, using PI.
d Draw the NPV profile for project SQ and
HT on the same set of axes, and use this
diagram to explain why the NPV and the
IRR show different preferences for these
two mutually exclusive projects. Discuss
this difference in terms of both the ‘scale
problem’ and the ‘timing problem’.
e Which of the two mutually exclusive
projects would you recommend that JK
Products undertake? Why?