Q28E - Horngren'S Financial And Managerial Accounting

Question

Mountain Manufacturing is considering the following capital investment proposals. Mountain’s requirement criteria include a maximum payback period of five years and a required rate of return of 12.5%. Determine if each investment is acceptable or should be rejected (ignore qualitative factors). Rank the acceptable investments in order from most desirable to least desirable

Project	A	B	C	D	E
Payback	3.15 years	4.20 years	2.00 years	3.25 years	5.00 years
NPV	\(10,250	\)42,226	(\(10,874)	\)36,251	$0
IRR	13.0%	14.2%	8.5%	14.0%	12.5%
Profitability index	1.54	1.92	0.75	2.86	1.00

Step-by-Step Solution

Answer

Project B

Project D

Project A

Project E

Project C

Step 1: Definition of Internal Rate of Return

The internal rate of return is the metric used in capital budgeting to determine the project’s profitability. IRR is calculated using the same formula as used for NPV. Under calculation of IRR net present value is considered as 0.

Step 2: Investment decision using the payback period

The maximum payback period is given as 5 years, and all the projects are having payback period equal to or less than five years. Therefore, according to the payback period, all projects will be accepted.

Step 3: Investment decision using NPV

A business entity must accept all the projects that have positive NPV. In the above cases, all projects have positive NPV except project C. Therefore; only project C will be rejected.

Step 4: Investment decision using IRR

The required rate of return is 12.5%, so any project providing a return below this will be rejected. Therefore, Project C will be rejected because it is having IRR of 8.5%.

Step 5: Investment decision using profitability index

When a decision is made using the profitability index, two things are considered positive NPV and a profitability index of more than 1. In the above case, Project C will be rejected because the profitability index of this project is less than one, and its NPV is negative.