Consider the following two mutually exclusive projects: Year Cash Flow (A) Cash
ID: 2796806 • Letter: C
Question
Consider the following two mutually exclusive projects:
Year
Cash Flow (A)
Cash Flow (B)
0
- $455,000
-$65,000
1
58,000
31,000
2
85,000
28,000
3
85,000
25,500
4
572,000
19,000
Your required rate of return is 15 percent.
a) If you apply the payback period criterion, which investment will you choose? Why?
b) If you apply the discounted payback period criterion, which investment will you choose? Why?
c)If you apply the NPV criterion, which investment will you choose? Why?
d) If you apply the IRR criterion, which investment will you choose? Why?
e) If you apply the profitability index criterion, which investment will you choose? Why?
f) Based on your answers in (a) through (e) above, which project will you finally choose? Why?
Year
Cash Flow (A)
Cash Flow (B)
0
- $455,000
-$65,000
1
58,000
31,000
2
85,000
28,000
3
85,000
25,500
4
572,000
19,000
Explanation / Answer
a.
Payback period = A + B/C
Where,
A = Last period with a negative cumulative cash flow;
B = Absolute value of cash flow at the end of the period A;
C = cash flow during the period after A.
Project A:
Payback period = 3 + 227000/572000 = 3.40 years
Project B:
Payback period = 2 + 6000/25500 = 2.24 years
Choose project B since payback period is least.
b.
Project A:
DPB = 3 + 284404.13/327042.86 = 3.87 years
Project B:
DPB = 3 + 104.79/10863.31 = 3.01 years
Choose project B, since DPB is least
c.
NPV is calculated by discounting the cashflows
PV = C/(1+r)^n
C - Cashflow
r - Discount rate
n - years to the cashflow
Project A:
Project B:
Choose project A, since NPV is higher
d.
IRR is the rate at which NPV = 0
Project A:
NPV = -455000 + 58000/(1+r)^1 + 85000/(1+r)^2 + 85000/(1+r)^3 + 572000/(1+r)^4 = 0
By trail and error, r = 18.15%
Project B:
NPV = -65000 + 31000/(1+r)^1 + 28000/(1+r)^2 + 25500/(1+r)^3 + 19000/(1+r)^4 = 0
r = 23.65%
Choose project B, since IRR is higher.
e.
PI = (NPV+Initial investment)/Initial investment
Project A:
PI = (42638.73+455000)/455000 = 1.09
Project B:
PI = (10758+65000)/65000 = 1.17
Choose project B, since PI is higher.
f. Choose project A, since the NPV is higher than project B.
NPV is the first criteria to be used in evaluating the projects.
Year Cashflow (A) Cumulative 0 -455000.00 -455000.00 1 58000.00 -397000.00 2 85000.00 -312000.00 3 85000.00 -227000.00 4 572000.00 345000.00