# Incremental Analysis and Capital Budgeting

U3 Company is considering three long-term capital investment proposals. Each investment has a useful life of 5 years. Relevant data on each project are as follows.

Depreciation is computed by the straight-line method with no salvage value. The company's cost of capital is 15%. (Assume that cash flows occur evenly throughout the year.)

### Instructions

1. Compute the cash payback period for each project. (Round to two decimals.)
2. Compute the net present value for each project. (Round to nearest dollar.)
3. Compute the annual rate of return for each project. (Round to two decimals.)
4. Rank the projects on each of the foregoing bases. Which project do yourecommend?

### Solution

(a) Project Bono \$160,000 / (\$14,000 + \$32,000) = 3.48 years

 Project Edge Year Cash Flow Cumulative Cash Flow 1 2 3 4 5 \$53,000 (\$18,000 + \$35,000) \$52,000 (\$17,000 + \$35,000) \$51,000 (\$16,000 + \$35,000) \$47,000 (\$12,000 + \$35,000) \$44,000 (\$ 9,000 + \$35,000) \$ 53,000 \$105,000 \$156,000 \$203,000 \$247,000

Cash payback period 3.40 years

\$175,000 - \$156,000 = \$19,000

\$19,000 / \$47,000 = .40

 Project Clayton Year Cash Flow Cumulative Cash Flow 1 2 3 4 5 \$67,000 (\$27,000 + \$40,000) \$63,000 (\$23,000 + \$40,000) \$61,000 (\$21,000 + \$40,000) \$53,000 (\$13,000 + \$40,000) \$52,000 (\$12,000 + \$40,000) \$ 67,000 \$130,000 \$191,000 \$244,000 \$296,000

Cash payback period 3.17 years

\$200,000 - \$191,000 = \$9,000

\$9,000 / \$53,000 = .17

(b) Project Bono

 Item Amount Years PV Factor Present Value Net annual cash flows Less: Capital investment Negative net present value \$46,000 1-5 3.35216 \$154,199 160,000 \$ (5,801)

 Project Edge Project Clayton Year Discount Factor Cash Flow PV Cash Flow PV 1 2 3 4 5 Total .86957 .75614 .65752 .57175 .49718 \$ 53,000 52,000 51,000 47,000 44,000 \$247,000 \$ 46,087 39,319 33,534 26,872 21,876 167,688 175,000    \$ (7,312) \$ 67,000 63,000 61,000 53,000 52,000 \$296,000 \$ 58,261 47,637 40,109 30,303 25,853 202,163 200,000    \$ 2,163 Less: Capital investment Positive (negative) net present value

(c) Project Bono = \$14,000 / [(\$160,000 + \$0) / 2] = 17.5%.

Project Edge = \$14,400 / [(\$175,000 + \$0) / 2] = 16.5%.

Project Clayton = \$19,200 / [(\$200,000 + \$0) / 2] = 19.2%.

 (d) Project Cash Payback Net Present Value Annual Rate of Return Bono Edge Clayton 3 2 1 2 3 1 2 3 1

The best project is Clayton.