1. As the discount rate increases, the present value of a given future cash flow also increases. Do you agree? Explain.
2. What is meant by the term payback period? How is the payback period determined?
How can the payback method be useful?
3. What is the major criticism of the payback and simple rate of return methods of making capital budgeting decisions
4. Wendell’s Donut Shoppe is investigating the purchase of a new $18,600 donut-making machine. The new machine would permit the company to reduce the amount of part-time help needed, at a cost savings of $3,800 per year. In addition, the new machine would allow the company to produce one new style of donut, resulting in the sale of 1,000 dozen more donuts each year. The company realizes a contribution margin of $1.20 per dozen donuts sold. The new machine would have a six- year useful life.
What would be the total annual cash inflows associated with the new machine for capital budgeting purposes?
Find the internal rate of return promised by the new machine to the nearest whole percent.
In addition to the data given previously, assume that the machine will have a $9,125 salvage value at the end of six years. Under these conditions, compute the internal rate of return to the nearest whole percent.
(Hint: You may find it helpful to use the net present value approach; find the discount rate that will cause the net present value to be closest to zero.)