Dino Corporation is trying to decide which of five investment opportunities it should undertake. The company's cost of capital is 16%. Owing to a cash shortage, the company has a policy that it will not undertake any investment unless it has a payback period of less than three years. The company is unwilling to undertake more than two investment projects. The following data apply to the alternatives:

Investment Initial Cost Expected Returns
A $100,000 $30,000 per year for 5 years
B 50,000 25,000 per year for 6 years
C 30,000 8,000 per year for 10 years
D 20,000 7,000 per year for 6 years
E 10,000 3,500 per year for 3 years

Required:

Using the payback method, screen out any investment project that fails to meet the company's payback period requirement.

Payback period is defined as the expected number of years required to recover the original investment.

Payback period = Initial investment/cash flow per year

Investment A
Payback period = 100,000/30,000 = 3.33 years

Investment B
Payback period = 50,000/25,000 = 2 years

Investment C
Payback period = 30,000/8,000 = 3.75 years

Investment D
Payback period = 20,000/7,000 = 2.86 years

Investment E
Payback period = 10,000/3,500 = 2.86 years

Reject Investment A and C.

Using the net present value method, determine which of the remaining projects the company should undertake, keeping in mind the capital rationing constraint.

Find NPV by finding the present value of each cash flow, including both inflows and outflows, discounted at the project's cost of capital.

NPV = sum of CFt where CF is the cash flow
(1 + k)t k is the cost of capital
t is the period.
Investment A
Payback period = -100,000 + 327,430 = 227,430

Investment B
Payback period = -50,000 + 92,118 = 42,118

Investment C
Payback period = -30,000 + 38,666 = 8,666

Investment D
Payback period = -20,000 +25,793 = 5,793

Investment E
Payback period = -10,000 + 7,861 = -2,139

The remaining projects to be taken are B and D.

Interpretive Question: What advantages do you see in using the payback method together with other capital budgeting methods?

By using the payback method, we would be able to rank the project's breakeven point before considering the cost of capital and help to screen out any investment project that fails to meet the company's payback period requirement.