Consider the following two mutually exclusive projects: Year Cash Flow (A) Cash
ID: 2758578 • Letter: C
Question
Consider the following two mutually exclusive projects:
Year Cash Flow (A) Cash Flow(B)
0 -$325,000 -$30,000
1 $43,000 $15,800
2 $51,000 $13,100
3 $69,000 $12,700
4 $480,000 $9,700
Whichever project you choose, if any, you require a 15% return on your investment.
A. If you apply the payback criterion, which investment will you choose? Why?
B. If you apply the NPV criterion, which invesment will you choose? Why?
C. If you apply the IRR criterion, which investment will you choose? Why?
D. If you apply the profitability index criterion, which investment will you choose ? Why?
E. Based on your answers in (a) through (d), whcih project will you finally choose? Why?
Explanation / Answer
Year Cash Flow(A) PV F @15% PV @ 15% Cumulative Pay back 0 -325000 1 -325000 -325000 1 43000 0.86957 37392 -287608 2 51000 0.75614 38563 -249045 3 69000 0.65752 45369 -203676 4 480000 0.57175 274440 70764 NPV 70764 Pay back period 3+ (203676/70764) 3+ 2.878243174 Ie. Approx 3yrs. 3 months Formula for Discounted Pay-back Period Discounted Payback Period = A+(B/C) A = Last period with a negative discounted cumulative cash flow; B = Absolute value of discounted cumulative cash flow at the end of the period A; C = Discounted cash flow during the period after A. Formula for IRR= 43000/(1+r)^1+51000/(1+r)^2+69000/(1+r)^3+480000/(1+r)^4-325000=0 Solving for r, we get r= 0.21908 or 22% IRR as per EXCEL 22% Profitability Index= 1+NPV/Initial Investment Reqd. 1+(70764/325000) 1.22 Year Cash Flow(B) PV F @15% PV @ 15% Cumulative Pay back 0 -30000 1 -30000 -30000 1 15800 0.86957 13739 -16261 2 13100 0.75614 9905 -6355 3 12700 0.65752 8351 1995 4 9700 0.57175 5546 7541 NPV 7541 Pay back period 2+ (6355/1995) 2+ 3.185463659 Ie. Approx 2yrs. 3 months IRR as per EXCEL 28% Formula for IRR= 15800/(1+r)^1+13100/(1+r)^2+12700/(1+r)^3+9700/(1+r)^4-30000=0 Solving for r, we get r= 0.28018 or 28% Profitability Index= 1+NPV/Initial Investment Reqd. 1+(7541/30000) 1.25 Project A Project B Project to be accepted A Pay back 3Y 3 M 2Y 3 M B B NPV 70764 7541 A C IRR 22 28 B D PI 1.22 1.25 B E. As PROJECT B scores over A in all criteria except NPV PROJECT B should be chosen.