Chapter 26, Problem 4BTN

To determine

Concept Introduction:

Capital budgeting is a planning process used to know whether a long term investment or options like to keep the old machine will be profitable or not involving factors like present value factors.

There are many capital budgeting techniques. The techniques that will be discussed here are −

Payback period of the investment and net present value

Payback period −Payback period of the investment is calculated as under −

  $Paybackperiod=\frac{InitialInvestment–Salvagevalueofoldequipment}{Annualnetcashinflow}$

This is how payback period is calculated in case of even annual net cash inflows.

Net present value:

The net present value is calculated as under −

  $Netpresentvalue=Totalpresentvalueofcashinflows-InitialInvestment$

Initial investment can be defined as the cash outlay incurred at the beginning of the product and total present value of cash inflows is computed as under (in case of even cash inflows) −

  $\begin{array}{l}Totalpresentvalueofcashinflows=Annualnetcashinflows\\ XPresentvalueofAnnuity\left(PVAF\right)atagivenrateforagivennumberofyears\end{array}$

This is how we calculate net present value of an investment.

To explain:

Four reasons that the international airlines such as Southwest or Delta would invest in a project when an analysis using both payback period and net present value indicate it to be a poor investment.