Problem: Growth Enterprises, Inc. (GEI) has $40 million that it can invest in any or all of the four capital investment projects, which have cash flows as shown in Table A below.
|
Type of |
|
|
|
|
| Project |
Type of Cash Flow |
Year 0 |
Year 1 |
Year 2 |
Year 3 |
| A |
Investment |
(10,000) |
|
|
|
|
Revenue |
|
21,000 |
|
|
|
Operationg Expenses |
|
11,000 |
|
|
|
|
|
|
|
|
| B |
Investment |
(10,000) |
|
|
|
|
Revenue |
|
15,000 |
17,000 |
|
|
Operationg Expenses |
|
5,833 |
7,833 |
|
|
|
|
|
|
|
| C |
Investment |
(10,000) |
|
|
|
|
Revenue |
|
10,000 |
11,000 |
30,000 |
|
Operationg Expenses |
|
5,555 |
4,889 |
15,555 |
|
|
|
|
|
|
| D |
Investment |
(10,000) |
|
|
|
|
Revenue |
|
30,000 |
10,000 |
5,000 |
|
Operationg Expenses |
|
15,555 |
5,555 |
2,222 |
Each of the projets is considered to be of equivalent risk. The investment will be depreciated to zero on a straight-line basis for tax purpose.
GEI's marginal corporate tax rate on taxable income is 40%. None of the projects will have any salvage value at the end of their respect lives.
For purposes of analysis, it should be assumend that all cash flows occur at the end of the yeat in question.
A) Rank GEI's four projects according to the following four commonly used capital budget criteria:
1) Payback period
2) Accounting return on investment. For purposes of this exercies, the accounting return onn investment should be defined as follows:
Average annual after-tax profits
(required investment)/2
3) Internal rate of Return
4) Net Presenst value, assuming alternately a 10% discount rate and a 35% discount rate
B) Why do the ranking differ? What does each technique measure and what assumptions does it make?
C) If the projects are independent of each other, which should be accepted? If they are mutally exclusive (i.e one and only one can be accepted), which one is the best?