Caledonia Project

FIN/370

Julie Vogt

January 9, 2012

Week 4 Team project was to answer question 12 a-e on page 363, Chapter 10 of Financial Management: Principles and Applications.

12. Caledonia is considering two additional mutually exclusive projects. The cash flows associated with these projects are as follows: YEAR | PROJECT A | PROJECT B | 0 | -$100,000 | -$100,000 | 1 | 32,000 | 0 | 2 | 32,000 | 0 | 3 | 32,000 | 0 | 4 | 32,000 | 0 | 5 | 32,000 | $200,000 |

The required rate of return on these projects is 11 percent. a. What is each project’s payback period? According to Financial Management: Principles and Applications Payback period is defined as “A capital-budgeting criterion defined as the number of years required to recover the initial cash investment” (Keown, Martin, Petty, & Scott, 2005, p. 292).

The equation for payback period is:

Payback period = Investment required / Net Annual Cash or Payback period = Y + (A / B)

Y = the number of years before final payback year

A = Total remaining to be paid back

B = Total (net) paid back in the entire payback of the year

(Keown, Martin, Petty, & Scott, 2005, p. 292).

Project A - payback period is 3.125 years.

The initial investment is $100,000. Each year Caledonia accumulates $32,000. Within a three-year period, $96,000 will be recovered ($32,000 x 3 = $96,000). The amount left from the initial investment is $4,000 ($100,000 - $96,000 = $4,000). This amount will be recovered in the fourth year. To recover the remaining $4,000, it will take an additional .125 years ($4,000/$32,000 = .125).

The formula used to come up with this was Payback period = 3 + ($4,000/$32,000) = 3 + .125 = 3.125 years

Project B - payback period is 4.5 years.

The initial investment is $100,000. It is assumed that Caledonia has no recovery until the fourth year. In the fifth year $200,000 is received. To

References: Keown, A.J., Martin, J.D., and Petty, J.W. (2005). Financial Management: Principles and Applications (10th ed.). Upper Saddle River, NJ: Pearson/Prentice Hall.