Doug’s Custom Construction Company is considering three new projects, each requi

Question

Doug’s Custom Construction Company is considering three new projects, each requiring an equipment investment of $21,660. Each project will last for 3 years and produce the following net annual cash flows.

The equipment’s salvage value is zero, and Doug uses straight-line depreciation. Doug will not accept any project with a cash payback period over 2 years. Doug’s required rate of return is 12%.

(For calculation purposes, use 5 decimal places as displayed in the factor table provided.)

A) Compute each project’s payback period. (Round answers to 2 decimal places, e.g. 15.25.)
B) Which is the most desirable project?
C) Which is the least desirable project?

Explanation / Answer

Answer

Part A)

Project AA

Unrecovered investment balance in year 3 = $21,660 - $21,090 = $570
Payback period = 2 years + (570 / 17,214) = 2 + 0.03 = 2.03 years

Project BB

Unrecovered investment balance in year 2 = $21,660 - $12,027 = $9,663
Payback period = 1 year + (9,663 / 12,027) = 1 + 0.80 = 1.80 years

Project CC

Unrecovered investment balance in year 2 = $21,660 - $14,934 = $6,726
Payback period = 1 year + (6,726 / 11,514) = 1 + 0.58 = 1.58 years

Part B)

Project AA is having a payback period of over 2 years hence, will not be accepted by Doug.

Calculation of NPV:

Project BB
NPV = $12,027 X PVIFA (12%,3yrs) - $21,660
= $12,027 X 2.4018 - $21,660
= $28,886.82 - $21,660
= $7,226.82

Project CC

Hence, the most desirable project is Project CC with highest NPV of $9,859.69 and is thus expected to create more shareholder's wealth than the other two projects.

Part C)

The least desirable project is project AA with the payback period of more than 2 years.

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