Construction is analyzing its capital expenditure proposals for the purchase of equipment in the coming year. The capital budget is limited to $5,000,000

for the year Lemon Baker,

staff analyst at Hafners

is preparing an analysis of the three projects under consideration by Corey Hafners, the company's owner.

Projected cash outflow Project A Project B Project C

Net initial investment $3,000,000 $2,100,000 $3,000,000

Projected cash inflows

Year 1 $1,200,000 $1,200,000 $1,700,000

Year 2 1,200,000 600,000 1,700,000

Year 3 1,200,000 500,000 200,000

Year 4 1,200,000 100,000

Required rate of return 12% 12% 12%

Requirement 1. Because the company's cash is limited,

Hafners

thinks the payback method should be used to choose between the capital budgeting projects.

a. What are the benefits and limitations of using the payback method to choose between projects?

Benefits of the payback method:

A.

Easy to understand and captures uncertainty about expected cash flows in later years of a project

B.

Utilizes the time value of money and computes each project's unique rate of return

C.

Indicates whether or not the project will earn the company's minimum required rate of return

D.

All of the above

Limitations of the payback method:

A.

Cannot be used for projects with unequal periodic cash flows

B.

Cannot be used when management's required rate of return varies from one period to the next.

C.

Fails to incorporate the time value of money and does not consider a project's cash flows after the payback period

D.

All of the above

b. Calculate the payback period for each of the three projects. Ignore income taxes. (Round your answers to two decimal places.)

Project A		years
Project B		years
Project C		years

Using the payback method, which project(s) should

HafnersHafners

choose?

Projects A, B, and C

Project A

Projects A and C

Project B

Projects B and C

Projects A and B

Project C

Requirement 2. Calculate the NPV for each project. Ignore income taxes. (Round your answers to the nearest whole dollar. Use parentheses or a minus sign for negative net presentvalues.)

The NPV of Project A is $

.

The NPV of Project B is $

.

The NPV of Project C is $

.

Requirement 3. Which projects, if any, would you recommend funding? Briefly explain why.

The

NPV

payback

method is generally regarded as the preferred method for project selection decisions, therefore, the company should consider investing in the project(s) with

a negative NPV.

a payback under 2 years.

a positive NPV.

the shortest payback period.

Since the company's is limited by the

number of capital investments

total dollar value of capital investments

it can make during the year, if more than one project fits this criteria, they should choose theinvestment(s) with the

greatest cash flow afer year 1 of the project.

greatest NPV.

greatest payback period.

lowest NPV.

shortest payback period.

Prior to making a final decision, the company should also consider the nonfinancial qualitative factors of the investments such as the

AARR and IRR.

fluctuations in the required rate of return.

the affect of inflation of the NPV calculations.

worker safety issues and customer confidence.

Using only the NPV calculations from requirement 2,

HafnersHafners

should invest in

Project C

Project B

Projects B and C

Project A

Projects A and C

Projects A and B

.