Capital Budgeting

Question

1. A startup landscaping company has to determine the most prudent investment in new trucks and mowers. They narrow their choice to two sets. Which set will be better given that money is worth 7.25%?

Capital Required   Set I     Set II
Initial cost ($)      68,000    65,000
Life span (years)   12         11
Maintenance ($)   5,000     4,500
Residual value ($) 7,000    6,000

 

2.Two investment proposals are submitted for approval of $25,000 each in initial investment. Their estimated profits after taxes are:
Year     Proposal 1 ($)   Proposal 2 ($)
1            2,500                6,000
2            3,300                 4,900
3            4,000                 4,200
4            5,200                 3,150
5            6,100                 2,000

 

Make a capital budgeting decision using the average rate of return method

 

3. Suppose that another couple of proposals is submitted for capital allocation. They have the following cash inflows:
Year          Proposal 1 ($)       Proposal 2 ($)
1              10,000                   5,500
2             10,500                    5,500
3              4,200                    5,500
4               1,900                   5,500
5               1,580                   5,500
Make a capital budgeting decision based on the payback period criteria if both projects require a $25,000 initial investment.

 

Answer 1

1. I am a little unsure what you mean by money is worth 7.25%  Do you mean interest rate?  And does the problem tell you to use a specific method i.e.(average rate of return, net present value?) 

 

2. Average rate of return: For each proposal: add up the returns and divide by how many you added up.  That gives you the Average return.  Then divide by the initial amount invested (25,000) and it will give you a decimal that can be changed to percent.This is your average rate of return. You want to take the proposal that gives you the higher Av. Rate of return since that means you get more money back per year on average.

 

3. Payback period is easy.  Look at the proposals and see which proposal gets you to or past 25,000 sooner.  The 25,000 is how much you invested and you want to be paid back the sooner the better.  If you loaned 2 friends each $50, and one paid you back $10 a month and another paid you back $20 the first month, and then $5 a month after, who pays you back sooner?  The first friend take 5 months and the second takes 7 months.  The problem with payback period(and Average rate of return) is that it doesn't take into account time value.