This mini-case provides a review of the methodology and rationale associated with the various capital budgeting evaluation methods such as payback period, discounted payback period, NPV, IRR, MIRR, and PI.
1. Compute the payback period for each project.
|Time of Cash Flow |Nano Test Tubes |Microsurgery Kit |
|Investment |−$11,000.00 |−$11,000.00 |
|Year 1 | 2,000.00 | 4,000.00 |
|Year 2 | 3,000.00 | 4,000.00 |
|Year 3 …show more content…
b. State and explain the decision rule behind the NPV method.
The decision rule for the NPV method is fairly obvious. Any NPV greater than $0.00 means the project is acceptable.
c. Explain how the NPV method would be used to rank mutually exclusive projects.
For mutually exclusive projects, one should simply choose the one with the largest NPV.
d. Comment on the advantages and shortcomings of this method.
Because the NPV method considers all cash flows through the life of the project and specifically incorporates the time value of money, it is considered to be the most reliable capital budgeting method.
e. Without performing any calculations, explain what happens to the NPV if the discount rate is adjusted upward for projects of higher risk or downward for projects of lower risk.
The NPV computation requires cash flows to be divided by (1 + r). Therefore, as long as negative cash flows are followed only by positive cash flows, higher values of r will lead to lower NPVs and vice-versa.
4. Compute the internal rate of return (IRR) for each project.
For Nano Test Tubes, the IRR is
$(11,000) + 2,000/1.20971 + 3,000/1.20972 + 4,000/1.20973 + 5,000/1.20974 + 7,000/1.20975 ’ $0.00