The company has not yet decided how the selected project will be financed. The c
ID: 2642788 • Letter: T
Question
The company has not yet decided how the selected project will be financed. The cost of capital or hurdle rate will vary depending upon how the company decides to finance the project. You decide to compare projects in three areas: (1) payback period (not considering the cost of capital); NPV sensitivity (see note 1 below); and (3) Internal Rate of Return (IRR).
Based on your analysis, which project would you recommend and why?
Project A Project B Project C Year Outflow Inflow Netflow Outflow Inflow Netflow Outflow Inflow Netflow 0 $150,000 -$150,000 $150,000 -$150,000 $200,000 $200,000 1 $20,000 $20,000 $130,000 $40,000 $90,000 $150,000 $150,000 2 $30,000 $30,000 $50,000 $50,000 $90,000 $90,000 3 $40,000 $40,000 $60,000 $60,000 $100,000 $100,000 4 $40,000 $40,000 $90,000 $90,000 $110,000 $110,000 5 $50,000 $50,000 $90,000 $90,000 $120,000 $120,000Explanation / Answer
Part 1:
Payback period is the period within which the initial investment (cost of the project)and cash outflows is recovered by the cash inflows.
______________
Solution:
Payback Period:
Project A:
We will take net outflows and inflows to calculate the payback period.
The initial outflow of 150,000 wil get recovered in Year 1 = $20,000, Year 2 = $30,000, Year 3 = $40,000, Year 4 = $40,000 and the balance amount of $20,000 between Year 4 and Year 5.
Payback Period = Partial Recovery Years + Balance Amount/Cash Inflow of the Year in which the Balance Amount is Recovered = 4 + 20,000/50,000 = 4.4 Years
________________
Project B:
We will take net outflows and inflows to calculate the payback period.
The outflow of $150,000 wil get recovered in Year 1 = $90,000, Year 2 = $50,000 and the balance amount of $10,000 between Year 2 and Year 3.
Payback Period = Partial Recovery Years + Balance Amount/Cash Inflow of the Year in which the Balance Amount is Recovered = 2 + 10,000/60,000 = 2.17 Years
________________
Project C:
We will take net outflows and inflows to calculate the payback period.
The initial outflows on $200,000 and $150,000 will get recovered in Year 2 = $90,000, Year 3 = $100,000, Year 4 = $110,000 and the balance of $50,000 between Year 3 and Year 4.
Payback Period = Partial Recovery Years + Balance Amount/Cash Inflow of the Year in which the Balance Amount is Recovered = 3 + 50,000/120,000 = 3.42 Years
__________________________
Part 2:
NPV is the difference between the present value of future cash inflows an cash flows including initial investment. It is one of the most important capital budgeting techniques used for making decisions on accepting or rejecting the project. If NPV is positive, the project is accepted, otherwise the project is rejected. Present value is calculated by discounting the future cash flows with the use of an appropriate discount rate.
Here, we have not been provided with the discount rate, so we will use net ouflows and inflows to calculate NPV. The formula here would be:
NPV = -Sum of Net Outflows + Sum of Net Inflows
______________
Solution:
NPV:
Project A = -150,000 + (20,000 + 30,000 + 40,000 + 40,000 + 50,000) = $30,000
________________
Project B = -150,000 + (90,000 + 50,000 + 60,000 + 90,000 + 90,000) = $230,000
________________
Project C = (-200,000 - 150,000) + (90,000 + 100,000 + 110,000 + 120,000) = $70,000
__________________________
Part 3:
Internal rate of return is the minimum rate of return required from a project. At this rate of return, the NPV is 0. IRR can be easily calculated with the of EXCEL/Financial Calculator with the use of IRR function. The general formulas for IRR is:
NPV = 0 = -Cash Outflow/(1+IRR)^1 + Cash Inflow/(1+IRR)^2 + Cash Inflow/(1+IRR)^3 and so on.
______________
Solution:
Project A:
IRR = 5.61%
________________
Project B:
IRR = 40.72%
________________
Project C:
IRR = 5.94%
_____________________________________
Project B should be selected as it has the lowest payback period, highest NPV and IRR.
Year Cash Flow 0 -150,000 1 20,000 2 30,000 3 40,000 4 40,000 5 50,000 IRR =IRR(-150000,20000,30000,40000,40000,50000)=5.61%