Question

Consider the following two mutually exclusive projects:

Year	CF of Project A	CF of Project 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

Whichever project you choose, if any, you require a 15 percent return on your investment.

a)If you apply the payback (PB) criterion, which investment will you choose? Why?

b)If you apply the NPV criterion, which investment will you choose? Why?

c)If you apply the IRR criterion, which investment will you choose? Why?

d)If you apply the profitability index (PI) criterion, which investment will you choose? Why?

e)Based on your answers in (a) through (d), which project will you finally choose?

Capital Budgeting Criteria	Project A	Project B	Project Chosen	Decision Rule
Payback (PB)
NPV
IRR
PI

Thank you in advance!

Answer 1

a.Project A

Payback period=full years until recovery + unrecovered cost at the start of the year/cash flow during the year

                             = 3 years + ($350,000 - $175,000)/ $440,000

                            = 3 years + $175,000/ $440,000

                            = 3 years + 0.40

                            = 3.40 years

Project B        

Payback period=full years until recovery + unrecovered cost at the start of the year/cash flow during the year

                             = 2 years + ($50,000 - $46,000)/ $19,500

                            = 2 years + $4,000/ $19,500

                            = 2 years + 0.21

                            = 2.21 years

Using the payback criterion, I would choose Project B since it has the shortest payback period.

b.Project A

Net present value can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$350,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the required return of 15%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The net present value is $32,589.76.

Project B

Net present value can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$50,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the required return of 15%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The net present value is $8,673.89

Project A should be selected as per the net present value since it has the highest net present value.

c. Project A

Internal rate of return can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$350,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR button and enter the interest rate to get the IRR of the project.

The IRR is 18.14%.

Project B

Internal rate of return can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$50,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR button and enter the interest rate to get the IRR of the project.

The IRR is 24.08%.

Project B should be selected as per the internal rate of return method since it has the highest internal rate of return.

d. Profitability index is calculated using the below formula:

Profitability Index= NPV + Initial investment/ Initial investment

Project A

Profitability Index= $32,589.76 + $350,000/ $350,000

                                   = $382,589.76/ $350,000

                                   = 1.09.

Project B

Profitability Index= $8,673.89 + $50,000/ $350,000

                                   = $58,673.89/ $50,000

                                   = 1.17.

Project B should be selected as per the profitability index method since it has the highest profitability index.

e.Based on my answers in a through d, I would choose project A since it has the highest net present value. The reason is that the NPV approach should be used for the capital budgeting decision. The project selected by the net present value will be able to maximize the wealth of the shareholders. The NPV method is more reliable compared to other methods in case of mutually exclusive projects.

In case of any query, kindly comment on the solution.