AST Company is attempting to select among the two mutuallyexclusive projects bot
ID: 2705509 • Letter: A
Question
AST Company is attempting to select among the two mutuallyexclusive projects both of
which cost Rs. 100,000. The firm has a cost of capital equalto 13%. After-tax cash
inflows associated with each project are shown in thefollowing table :
Year Project A (Rs.) Project B (Rs.)
1 40,000 45,000
2 25,000 25,000
3 35,000 20,000
4 25,000 20,000
5 20,000 20,000
REQUIRED :
(i) Calculate the Payback Period for each project. (2+3)
(ii) Calculate the Net Present Value (NPV) of each project.(5+5)
(iii) Calculate the Internal Rate of Return (IRR) for eachproject. (6+6)
(IRR must be calculated by using
Explanation / Answer
Answer:
i) Calculate the Payback Period for eachproject.
Initial Investment = 100,000
Payback Period for Project A:
In year one, 40,000 will be covered, and (100,000-40,000) =60,000 should be covered.
In year two, further 25,000 will be covered, and (60,000-25,000)= 35,000 should be covered.
In year three, 35,000 will be covered, which we have to coverfrom the project.
So, our payback period is 3 years for ProjectA.
Payback Period for Project B:
In year one, 45,000 will be covered, and (100,000-45,000) =55,000 should be covered.
In year two, further 25,000 will be covered, and (55,000-25,000)= 30,000 should be covered.
In year three, 20,000 will be covered, and (30,000-20,000) =10,000 should be covered yet.
In year four, 20,000 will be covered, but we have to cover10,000 only,
So these 10,000 will take the time in years = 10,000/20,000 =0.5 years
OR 10,000 will take the time in months = 10,000/20,000 * 12 = 6months
OR 10,000 will take the time in days = 10,000/20,000 * 365 =182.5 days
So, payback period for Project B is 3.5 years, or 3years and 6 months or 3 years and 182.5 days.
ii) Calculate the Net Present Value (NPV) ofeach project.
NPV for Project A:
NPV = -Initial Investment + ? Cash Flows / (1+r)t
NPV = -100,000 + [40,000 / (1+0.13) 1] + [25,000 /(1+0.13) 2] + [35,000 / (1+0.13) 3] + [25,000/ (1+0.13) 4] + [20,000 / (1+0.13) 5]
NPV = -100,000 + [40,000 / (1.13) 1] + [25,000 /(1.13) 2] + [35,000 / (1.13) 3] + [25,000 /(1.13) 4] + [20,000 / (1.13) 5]
NPV = -100,000 + [40,000 / 1.13] + [25,000 / 1.2769] + [35,000 /1.442897] + [25,000 / 1.63047361] + [20,000 / 1.8424351793]
NPV = -100,000 + [35398.23] + [19578.67] + [24256.76] +[15332.97] + [10855.2]
NPV = 5421.83
NPV for Project B:
NPV = -Initial Investment + ? Cash Flows / (1+r)t
NPV = -100,000 + [45,000 / (1+0.13) 1] + [25,000 /(1+0.13) 2] + [20,000 / (1+0.13) 3] + [20,000/ (1+0.13) 4] + [20,000 / (1+0.13) 5]
NPV = -100,000 + [45,000 / (1.13) 1] + [25,000 /(1.13) 2] + [20,000 / (1.13) 3] + [20,000 /(1.13) 4] + [20,000 / (1.13) 5]
NPV = -100,000 + [45,000 / 1.13] + [25,000 / 1.2769] + [20,000 /1.442897] + [20,000 / 1.63047361] + [20,000 / 1.8424351793]
NPV = -100,000 + [39823] + [19578.67] + [13861] + [12266.37] +[10855.2]
NPV = -3615.76
iii) Calculate the Internal Rate of Return(IRR) for each project.
Internal rate of return (IRR) is a rate where, NPV becomes zerolet