Question

Nicholson Roofing​ Materials, Inc., is considering two mutually exclusive​ projects, each with an initial investment of ​$110,000. The​ company's board of directors has set a​ 4-year payback requirement and has set its cost of capital at 12​%. The cash inflows associated with the two projects are shown in the following ​table:

Cash inflows ​(CFt​)
Year	Project A		Project B
1	​$35,000		​$65,000
2	​$35,000		​$50,000
3	​$35,000		​$20,000
4	​$35,000		​$20,000
5	​$35,000		​$20,000
6	​$35,000		​$20,000

a. Calculate the payback period for each project. Rank the projects by payback period.

b.  Calculate the NPV of each project. Rank the project by NPV.

c.  Calculate the IRR of each project. Rank the project by IRR.

d.  Make a recommendation.

Answer 1

Payback period for Project A :

= 3 + $5,000/ $35,000

= 3.1429 years

Payback period for project B :

= $1 + $45,000/ $50,000

= 1.9 years

So, the project B has a shorter time period for the recovery of the investment than project A . Hence, project B should be ranked higher than Project A.

The NPV of the projects are :

= ($110,000) + $35,000/1.12 + $35,000/1.12^2 + .....$35,000/1.12^6

= $33,899.2563

Similarly for project B the NPV is .

= $36,322,5342

On the basis of NPV, project B is ranked higher than project A because it has a higher NPV.

c. The IRR can be calculated as:

($110,000) + $35,000/(1 + IRR)^1 + $35,000/ (1 + IRR)^2 + .........$35,000/ (1 + IRR)^5

So, the IRR is 22.318%

Similarly for project B,

The IRR of this project is 27.2489.

On the basis of IRR, the project B is ranked higher than project A.

The Project with the highest NPV should be chosen , so the recommendation is to choose project B. On the basis of other parameters like payback period and IRR also favors project B.