Consider the following two mutually exclusive projects: Whichever project you ch
ID: 2714072 • Letter: C
Question
Consider the following two mutually exclusive projects: Whichever project you choose, if any, you require a return of 11 percent on your investment. If you apply the payback criterion, which investment will you choose? Why? If you apply the discounted payback criterion, which investment will you choose? Why? If you apply the NPV criterion, which investment will you choose? Why? If you apply the IRR criterion, which investment will you choose? Why? If you apply the profitability index criterion, which investment will you choose? Why? Based on your answers in (a) through (e), which project will you finally choose? Why?Explanation / Answer
17.a) Amount (in $) Calculation of Payback Period Project A Project B Cash Outflow 455000.00 65000.00 The Cash Outflow for Project A is recovered in Year 1 Cash Inflow 58000.00 Year 2 Cash Inflow 85000.00 Year 3 Cash Inflow 85000.00 Difference 227000.00 Year 4 Cash Inflow 572000.00 The difference of $227,000.00 will be recovered in 4th year in 4.76 months 4.76 The Cash Outflow for Project B is recovered in Year 1 Cash Inflow 31000.00 Year 2 Cash Inflow 28000.00 Difference 6000.00 Year 3 Cash Inflow 25500.00 The difference of $6,000.00 will be recovered in 3rd year in 4.76 months 2.82 The payback period for Project A is 3 years and 4.76 months and the payback period for Project B is 2 years and 2.82 months. Thus based on payback criterion we will choose Project B since the payback period is shorter. 17.b) Discounted Payback period for Project A Amount (in $) Year n Cash Flow CF Present Value Factor PV$1=1/(1+i)n Discounted Cash Flow CF×PV$1 Cumulative Discounted Cash Flow 0 -455000.00 1.00 -455000.00 -455000.00 1 58000.00 0.90 52252.25 -402747.75 2 85000.00 0.81 68987.91 -333759.84 3 85000.00 0.73 62151.27 -271608.57 4 572000.00 0.66 376794.12 105185.54 Step 2: Discounted Payback Period = 3 + |-271,608.57| / 376,794.12 3.72 years Discounted Payback period for Project B Amount (in $) Year n Cash Flow CF Present Value Factor PV$1=1/(1+i)n Discounted Cash Flow CF×PV$1 Cumulative Discounted Cash Flow 0 -65000.00 1.00 -65000.00 -65000.00 1 31000.00 0.90 27927.93 -37072.07 2 28000.00 0.81 22725.43 -14346.64 3 25500.00 0.73 18645.38 4298.74 4 19000.00 0.66 12515.89 16814.62 Step 2: Discounted Payback Period = 2 + |-14,346.64| / 18,645.38 2.77 years The discounted payback period for Project A is 3.72 years and the discounted payback period for Project B is 2.77 years. Thus based on discounted payback criterion we will choose Project B since the payback period is shorter. 17.c) NPV for Project A Amount (in $) Year n Cash Flow CF Present Value Factor PV$1=1/(1+i)n Discounted Cash Flow CF×PV$1 NPV of Project A 0 -455000.00 1.00 -455000.00 -455000.00 1 58000.00 0.90 52252.25 -402747.75 2 85000.00 0.81 68987.91 -333759.84 3 85000.00 0.73 62151.27 -271608.57 4 572000.00 0.66 376794.12 105185.54 NPV of Project A is $105,185.54 NPV for Project B Amount (in $) Year n Cash Flow CF Present Value Factor PV$1=1/(1+i)n Discounted Cash Flow CF×PV$1 NPV for Project B 0 -65000.00 1.00 -65000.00 -65000.00 1 31000.00 0.90 27927.93 -37072.07 2 28000.00 0.81 22725.43 -14346.64 3 25500.00 0.73 18645.38 4298.74 4 19000.00 0.66 12515.89 16814.62 NPV of Project B is $16,814.62 The NPV for Project A is $105,185.54 and the NPV for Project B is $16,814.62. Thus based on NPV criterion we will choose Project A since its has a higher NPV. 17.d) IRR for Project A Amount (in $) Year n Cash Flow CF Present Value Factor PV$1=1/(1+i)n Discounted Cash Flow CF×PV$1 NPV of Project A 0 -455000.00 1.00 -455000.00 -455000.00 1 58000.00 0.85 49088.39 -405911.61 2 85000.00 0.72 60886.44 -345025.16 3 85000.00 0.61 51531.34 -293493.82 4 572000.00 0.51 293494.10 0.27 IRR of Project A using excel is calculated as 18.1542%. IRR for Project B Amount (in $) Year n Cash Flow CF Present Value Factor PV$1=1/(1+i)n Discounted Cash Flow CF×PV$1 NPV for Project B 0 -65000.00 1.00 -65000.00 -65000.00 1 31000.00 0.81 25070.69 -39929.31 2 28000.00 0.65 18313.33 -21615.98 3 25500.00 0.53 13488.20 -8127.78 4 19000.00 0.43 8127.78 0.00 IRR of Project B using excel is calculated as 23.65036%. The IRR for Project A is 18.1542% and the IRR for Project B is 23.65036%. Thus based on IRR criterion we will choose Project B since its has a higher IRR. 17. e) Profitability Index = Present Value of Future Cash Flows/Initial Investment Required or = 1 + Net Present Value/Initial Investment Required Amount (in $) Calculation of Payback Period Project A Project B Cash Outflow 455000.00 65000.00 NPV 105185.54 16814.62 Profitability Index 1.23 1.26 The profitability index for Project A is 1.23 and the profitability index for Project B is 1.26. Thus based on profitability index criterion we will choose Project B since the profitability index is higher. 17.f) If the project are mutually exclusive, it means the company can select any one of the projects. It can’t invest simultaneously in all the projects. In such situation, the company should opt for projects generating the maximum net present value i.e. Project A. Although Project B has higher IRR , in case of mutually exclusive projects, a decision based on net present value is theoretically sounder.