Answers to Mini-Case Questions

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( Answers to Mini-Case Questions

BioCom Inc.
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 | 4,000.00 | 4,000.00 | |Year 4 | 5,000.00 | 4,000.00 | |Year 5 | 7,000.00 | 4,000.00 |

Payback for Nano: cash flows for the first three years total $9,000. (11,000 − 9,000)/4,000 ’ .5, so payback for Nano is 3.5 years. For Microsurgery: cash flows for the first two years total $8,000. (11,000 − 8,000)/4,000 ’ 0.75, so payback for Microsurgery is 2.75 years. a.Explain the rationale behind the payback method.

The payback simply computes the break-even point for a project in terms of time rather than units or dollars. It is the amount of time required for a project to recover the initial investment.

b.State and explain the decision rule for the payback method.

The payback method implies that the sooner a project recovers the initial investment, the better. The choice of an acceptable payback period is arbitrary.

c.Explain how the payback method would be used to rank mutually exclusive projects.

For acceptable mutually exclusive projects, the one with the shortest payback period would be chosen.

d.Comment on the advantages and shortcomings of this method.

Payback is simple to compute and the logic is obvious, even to people with no background in finance. However, the method does not formally recognize the time value of money, it ignores cash flows that occur after the payback period, and it does not necessarily select projects that add value to the company, or discriminate between projects that add more or less value. 2.Compute the discounted payback period for each project using a discount rate of 10%.

|Nano Test Tubes | |Year |PV of CF at 10% |Remaining cost to recover | |0 |$ (11.000.00) | | |1 |2,000/1.101 ’ 1,818.18 |−9,181.82 | |2 |3,000/1.102 ’ 2,479.34 |−6,702.48 | |3 |4,000/1.103 ’ 3,005.26 |−3,697.22 | |4 |5,000/1.104 ’ 3,415.07 |−282.15 | |5 |7,000/1.105 ’ 4,346.45 |4,064.30 | | |In (000’s) | |

|Microsurgery Kit | |Year |PV of CF at 10% |Remaining cost to recover | |0 |($11,000.00) |  | |1 |4,000/1.101 ’ 3,636.36 |−7,363.64 | |2 |4,000/1.102 ’ 3,305.79 |−4,057.85...
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