Medical Technology Enterprises is trying to select the best investment from amon
ID: 2797546 • Letter: M
Question
Medical Technology Enterprises is trying to select the best investment from among four alternatives. Each alternative involves an initial outlay of $100,000. and the company’s cost of capital (WACC) is 10%. Their future cash flows follow:
Year
Alternative A ($)
Alternative B (S)
Alternative C ($)
Alternative D ($)
Initial cost
-100,000
-100,000
-100,000
-100,000
1
10,000
50,000
25,000
0
2
20,000
40,000
25,000
0
3
30,000
30,000
25,000
45,000
4
40,000
0
25,000
55,000
5
50,000
0
25,000
60,000
Evaluate and rank each alternative based on (PLEASE SHOW YOUR WORK):
a) Payback period,
Alternative A: ___________________ Rank (1st, 2nd, 3rd, 4th) __________
Alternative B: ___________________ Rank (1st, 2nd, 3rd, 4th) ___________
Alternative C: ____________________ Rank (1st, 2nd, 3rd, 4th) ___________
Alternative D: ____________________ Rank (1st, 2nd, 3rd, 4th) ___________
b) Net present value (use a 10% discount rate),
Alternative A: ___________________ Rank (1st, 2nd, 3rd, 4th) __________
Alternative B: ___________________ Rank (1st, 2nd, 3rd, 4th) __________
Alternative C: ____________________ Rank (1st, 2nd, 3rd, 4th) __________
Alternative D: Rank (1st, 2nd, 3rd, 4th) __________
c) Internal rate of return.
Alternative A: ___________________ Rank (1st, 2nd, 3rd, 4th) __________
Alternative B: ___________________ Rank (1st, 2nd, 3rd, 4th) __________
Alternative C: ____________________ Rank (1st, 2nd, 3rd, 4th) __________
Alternative D: Rank (1st, 2nd, 3rd, 4th) __________
Year
Alternative A ($)
Alternative B (S)
Alternative C ($)
Alternative D ($)
Initial cost
-100,000
-100,000
-100,000
-100,000
1
10,000
50,000
25,000
0
2
20,000
40,000
25,000
0
3
30,000
30,000
25,000
45,000
4
40,000
0
25,000
55,000
5
50,000
0
25,000
60,000
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 = 4 years
Project B:
Payback period = 2 + 10000/30000 = 2.33 years
Project C:
Payback period = 4 years
Project D:
Project B - 1st
Project D - 2nd
Project A - 3rd
Project C - 4th
NPV:
NPV is calculated by discounting the cashflows
PV = C/(1+r)^n
C - Cashflow
r - Discount rate
n - years to the cashflow
Project A:
NPV = -100000 + 10000/ (1+0.1)^1 + 20000/(1+0.1)^2 + 30000/(1+0.1)^3 + 40000/(1+0.1)^4 + 50000/(1+0.1)^5 = $6525.88
Project B:
NPV = -100000 + 50000/ (1+0.1)^1 + 40000/(1+0.1)^2 + 30000/(1+0.1)^3 + 0/(1+0.1)^4 + 0/(1+0.1)^5 = $1051.84
Project C:
NPV = -100000 + 25000/ (1+0.1)^1 + 25000/(1+0.1)^2 + 25000/(1+0.1)^3 + 25000/(1+0.1)^4 + 25000/(1+0.1)^5 = $-5230.33
Project D:
NPV = -100000 + 0/ (1+0.1)^1 + 0/(1+0.1)^2 + 45000/(1+0.1)^3 + 55000/(1+0.1)^4 + 60000/(1+0.1)^5 = $8630.19
Project D - Rank 1
Project A - Rank 2
Project B - Rank 3
Project C - Rank 4
IRR is the rate at which NPV = 0
Project A:
NPV = -100000 + 10000/ (1+IRR)^1 + 20000/(1+IRR)^2 + 30000/(1+IRR)^3 + 40000/(1+IRR)^4 + 50000/(1+IRR)^5 = 0
By trail and error, IRR = 12.01%
Project B:
NPV = -100000 + 50000/ (1+IRR)^1 + 40000/(1+IRR)^2 + 30000/(1+IRR)^3 + 0/(1+IRR)^4 + 0/(1+IRR)^5 = 0
By trail and error, IRR = 10.65%
Project C:
NPV = -100000 + 25000/ (1+IRR)^1 + 25000/(1+IRR)^2 + 25000/(1+IRR)^3 + 25000/(1+IRR)^4 + 25000/(1+IRR)^5 = 0
By trail and error, IRR = 7.93%
Project D:
NPV = -100000 + 25000/ (1+IRR)^1 + 25000/(1+IRR)^2 + 25000/(1+IRR)^3 + 25000/(1+IRR)^4 + 25000/(1+IRR)^5 = 0
By trail and error, IRR = 12.29%
Project D - Rank 1
Project A - Rank 2
Project B - Rank 3
Project C - Rank 4
Year Cashflow (A) Cumulative 0 -100000.00 -100000.00 1 10000.00 -90000.00 2 20000.00 -70000.00 3 30000.00 -40000.00 4 40000.00 0.00 5 50000.00 50000.00