Review Problem: Comparison of Capital Budgeting Methods

Lamar Company is considering a project that would have an eight-year life and require a $2,400,000 investment in
equipment. At the end of eight years, the project would terminate and the equipment would have no salvage
value. The project would provide net operating income each year as follows:

Sales $ 3,000,000
Variable expenses 1,800,000
Contribution margin 1,200,000
Fixed expenses:
Advertising, salaries, and other
$700,000
fixed out-of-pocket costs
Depreciation 300,000
Total fixed expenses 1,000,000
Net operating income $ 200,000

The companys discount rate is 12%.

Required:
a. Compute the annual net cash inflow from the project.
b. Compute the projects net present value. Is the project acceptable?
c. Find the projects internal rate of return to the nearest whole percent.
d. Compute the projects payback period.
e. Compute the projects simple rate of return.

Solution to Review Problem

1. The annual net cash inflow can be computed by deducting the cash expenses from sales:

Sales $ 3,000,000
Variable expenses 1,800,000
Contribution margin 1,200,000
Advertising, salaries, and other
700,000
fixed out-of-pocket costs
Net operating income $ 500,000

Or, the annual net cash inflow can be computed by adding depreciation back to net operating income:

Net operating income $ 200,000

Add: Noncash deduction for depreciation 300,000
Annual net cash inflow 500,000

2. The net present value is computed as follows:

Amount of 12% Present value

Item Year(s)
cash flows factor of cash flows
Cost of new equipment Now ($2,400,000) 1.000 ($2,400,000)
Annual net cash inflow 18 $500,000 4.968 2,484,000
Net present value $84,000

Yes, the project is acceptable because it has a positive net present value.
 3. The formula for computing the factor of the internal rate of return is:

Investment required
Factor of the internal rate of return =
Annual net cash inflow

$ 2,400,000.00
=
$ 500,000.00

= 4.8000
Looking in Time value table and scanning along the 8-period line, we find that a factor of 4.800 represents a rate
of return of about 13%.

4. The formula for the payback period is:

Investment required
Payback period =
Annual net cash inflow

$ 2,400,000.00
=
$ 500,000.00

= 4.8 years

5. The formula for the simple rate of return is:

Annual incremental net operating income

Simple rate of return =
Initial investment

$ 200,000
=
$ 2,400,000

= 8.30%