Evaluate The Strengths And Weaknesses Of The Cash Payback Period

Module 2 Critical Thinking
4. Evaluate the strengths and weaknesses of the Cash Payback Period, Discounted Cash Payback Period, NPV, IRR and MIRR capital expenditure budgeting methods. Prepare a recommendation for Stewart regarding the capital budgeting method or methods to use in evaluating the expansion alternatives. Support your answer.
Capital budgeting techniques such as payback period, net present value (NPV), internal rate of return (IRR) and modified internal rate of return (MIRR) all offer particular strengths and weaknesses. The payback period is the simplest capital budgeting method and helps determine how long it will take to pay back a projects initial investment by focusing on cash flows during the payback period. While this
Furthermore, the new equipment also has an IRR above the 15% WACC and a positive NPV. However, the used equipment option would provide greater returns, than the new equipment will.
6. Stewart is concerned that the projected annual sales growth rate of 15% for incremental blended material may be optimistic. Recalculate the Cash Payback Period, Discounted Cash Payback Period, NPV, IRR and MIRR for each alternative assuming the annual sales growth rates of 10% and 5%. Assume a WACC of 15%. Does the change in growth rate alter the recommendation made in question 5? Solution requires preparation of spreadsheets. Explain.
10% Sales Growth Used Equipment New Equipment
Payback Period in Years = 2.33 5.11
Discounted Payback Period = 2.78 Greater than 7
NPV = $ 19,571.97 $ (29,330.93)
IRR = 20.9% 13.2%
MIRR = 19.3% 14.0%

5% Sales Growth Used Equipment New Equipment
Payback Period in Years = 2.34 5.32
Discounted Payback Period = 2.82 Greater than 7
NPV = $ 14,894.96 $ (64,869.06)
IRR = 19.6%
However, for new equipment the IRR dropped below the acceptable 15% WACC for both 10% and 5% sales growth rates. Moreover, the NPV also dropped below zero indicating a net loss if Cape Chemical has either 10% or 5% growth rates. Therefore, under these sales parameters the new equipment option should be rejected.
7. The projected cash flow benefits of both projects did not include the effects of inflation. Future cash flows were determined using a constant selling price and operating costs (real cash flows). The cash flows were then discounted using a WACC that included the impact of inflation (nominal WACC). Discuss the problem with using real cash flows and a nominal WACC when calculating a project’s Discounted Payback Period, NPV, IRR and