Consider the following two mutually exclusive projects: Suppose you require a 15

Question

Consider the following two mutually exclusive projects: Suppose you require a 15 % return on your investment. (30 points)

Cash Flow(A)

Cash Flow(B)

Using the payback criterion, which investment should you choose? Suppose that the sooner the better.

By the NPV criterion, which would you choose?

By the IRR criterion, which would you choose?

Are the results in (a), (b) and (c) consistent? Which one should we use?

Years

Cash Flow(A)

Cash Flow(B)

0   -$350,000   -$50,000 1 45,000 $ 24,000 2 65,000 $22,000 3 65,000 $19,500 4 440,000 $14,600

Explanation / Answer

  PROJECT A PROJECT B

  YEAR CASH FLOW CUMULATIVE CASH FLOW CASH FLOW CUMULATIVE CASH FLOW

0 -350000 ------- -50000 -------

1 45000 45000 24000 24000

2 65000 110000 22000 46000

3 65000 175000 19500 65500

   4 440000 615000 14600 80100

PAYBACK PERIOD (A) (B)

   = 3 + 175000(350000-175000) / 440000 = 2 + 4000(50000-46000) / 19500

   = 3 + 0.4 = 2 + 0.21

= 3.34 YEARS = 2.21 YEARS

According to Payback Period Project B should be opted.

   PROJECT A

YEAR CASH FLOW PV FACTOR (15%) PRESENT VALUE OF CASH FLOW

   0 -350000 1 -350000

   1 45000 0.870 39150

   2 65000 0.756 49140

3 65000 0.658 42770

   4 440000 0.572 251680

     NET PRESENT VALUE $ 32170

PROJECT B

YEAR CASH FLOW PV FACTOR (15%) PRESENT VALUE OF CASH FLOW

0 -50000 1 -50000

1 24000 0.870 20880

2 22000 0.756 16632

3 19500 0.658 12831

4 14600 0.572 8351

  NET PRESENT VALUE $ 8694

Thus according to Net Present Value Project Ashould be opted.

Results of according to payback period and NPV are inconsistent with each other

Decision should be taken on the basis of NPV criterion

We should opt Project A having higher NPV than Project B

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