## Calculating Payback and Profitability

07 Mar

Questions to Consider

To deepen your understanding, you are encouraged to consider the questions below and discuss them with a fellow learner, a work associate, an interested friend, or a member of the business community.

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• How would you define the following capital budgeting methods: net present value (NPV), internal rate of return (IRR), and payback period? How do they differ from one another? What are some other capital budgeting methods? Which, if any, of the methods might be superior to the others?
• What are some concepts associated with making capital investment decisions such as cash flows, sunk costs, or opportunity costs? Why should an investor factor these concepts into the decision-making process?

Assessment Instructions

Demonstrate your understanding of financial concepts by completing the following problems. Where appropriate, show or explain your work. You may use Excel to work on the problems.

Problem 1. Calculating net present value (NPV): Porter Incorporated has two exclusive projects, listed in the table below. Use the NPV rule to rank these two projects. If the appropriate discount rate is 13 percent, which project should be chosen?

 Problem 1. Calculating NPV Year Project A Project B 0 −\$12,700 −\$9,400 1 \$7,000 \$4,800 2 \$5,500 \$3,750 3 \$2,500 \$3,400

Problem 2. Calculating payback period: An investment project provides cash inflows of \$920 per year for eight years. Calculate the project’s payback period if the initial cost is each of the following:

• \$4,500.
• \$5,500.
• \$7,000.

Problem 3. Calculating internal rate of return (IRR) for cash flows: Calculate the internal rate of return for the cash flows of the two projects in the table below.

 Problem 3. Calculating IRR for Cash Flows Year Project A Project B 0 −\$4,600 −\$3,500 1 \$1,400 \$1,250 2 \$2,200 \$1,800 3 \$2,700 \$1,600

Problem 4. Calculating profitability index of a project: Jeff plans to open a small health club. The equipment will cost \$225,000. Jeff expects that there will be after-tax cash inflows of \$62,000 annually for seven years. The equipment will then be scrapped and the health club will close. At year-end of the first year, the first cash inflow occurs. The required return is 13 percent. What is the project’s profitability index? Should it be accepted?

Problem 5. Calculating project NPV: Jenny’s Creamery is considering the purchase of a \$27,000 ice cream maker. The ice cream maker has an economic life of eight years. Using the straight-line method, it will be fully depreciated. The machine will produce 250,000 servings per year, with each costing \$1.25 to make, and priced at \$1.99. The discount rate is 12 percent. The tax rate is 35 percent. Should the company make the purchase? Provide a rationale using the calculations.