Problem 26-5A (Part Level Submission) (a) Problem 26-5A (Part Level Submission)

Question

Problem 26-5A (Part Level Submission)

(a)

Problem 26-5A (Part Level Submission)

U3 Company is considering three long-term capital investment proposals. Each investment has a useful life of 5 years. Relevant data on each project are as follows.
Project Bono Project Edge Project Clayton Capital investment $168,000 $183,750 $202,000 Annual net income: Year  1 14,700 18,900 28,350         2 14,700 17,850 24,150         3 14,700 16,800 22,050         4 14,700 12,600 13,650         5 14,700 9,450 12,600 Total $73,500 $75,600 $100,800
Depreciation is computed by the straight-line method with no salvage value. The company’s cost of capital is 15%. (Assume that cash flows occur evenly throughout the year.)

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Explanation / Answer

Solution:

U3 Company

Computation of cash payback period for each project:

cash payback period

Project Bono

3.48

Project Edge

3.4

Project Clayton

3.12

      Cash payback period for project Bono –

Project Bono records uniform annual cash inflows. Hence, the formula for cash payback period is as follows,

Cash payback period = initial investment/cash inflow per annum

Since, depreciation is a non-cash expense, the same is added to cash inflow to arrive at net annual cash inflow.

Depreciation expense = $168,000/5 years = $33,600

Net annual cash inflows = $14,700 + $33,600 = $48,300 = 3.48 years

Cash payback period for Project Edge:

Since the cash inflows for Project Edge are not uniform we adopt a different approach. The first step is to identify the year in which the cumulative cash inflows x        are almost nearer to initial investment.

Depreciation = 183,750/5 = $36,750

Project Edge

Year

Cash inflows

Depreciation

Cumulative Cash inflows

1

$18,900

$36,750

$55,650

2

$17,850

$36,750

$110,250

3

$16,800

$36,750

$163,800

4

$12,600

$36,750

$213,150

5

9,450

$36,750

$259,350

At year 3, the cumulative cash inflows are nearer to the initial investment of $183,750

The difference, 183,750 – 163,800 = $19,950

19,950/ (12,600 + 36,750) = 0.40years

Hence, the cash payback period for Project Edge = 3 + 0.40 years = 3.40 years

Project Clayton:

Depreciation = $202,000/5 = $40,400

Year

Cash inflows

Depreciation

Cumulative Cash inflows

1

$28,350

$40,400

$68,750

2

$24,150

$40,400

$133,300

3

$22,050

$40,400

$195,750

4

$13,650

$40,400

$249,800

5

12,600

$40,400

$302,800

At the end of year 3, the cumulative cash inflow is $195,750 which is nearer to initial investment of $202,000.

The difference =202,000 – 195,750 = $6,250

6,250/ (13,650 + 40,400) = 0.12 years

Hence the cash payback for Project Clayton is 3 + 0.12 years = 3.12 years

cash payback period

Project Bono

3.48

Project Edge

3.4

Project Clayton

3.12

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