Question

10. Consider the following two mutually exclusive projects: Year Cash Flow (A) - $175,000 10,000 25,000 25,000 375,000 Cash Flow (B) - $20,000 10,000 5,000 3,000 1,000 Whichever project you choose, if any, you require a 15 percent return on your investment. a. If you apply the payback criterion, which investment will you choose? b. If you apply the NPV criterion, which investment will you choose? c. If you apply the IRR criterion, which investment will you choose? d. Based on your answers in (a) through (c), which project will you finally choose? Why?

Answer 1

		Present Value(PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=discount rate=Minimum required return =15%=0.15
		N=Year of Cash Flow
		N	A		PVA=A/(1.15^N)	B		PVB=B/(1.15^N)
				Cumulative	Present Value		Cumulative	Present Value
		Year	Cash Flow A	Cash Flow A	of Cash FlowA	Cash Flow B	Cash Flow B	of Cash FlowB
		0	($175,000)	($175,000)	($175,000)	($20,000)	($20,000)	($20,000)
		1	$10,000	($165,000)	$8,696	$10,000	($10,000)	$8,696
		2	$25,000	($140,000)	$18,904	$5,000	($5,000)	$3,781
		3	$25,000	($115,000)	$16,438	$3,000	($2,000)	$1,973
		4	$375,000	$260,000	$214,407	$1,000	($1,000)	$572
				SUM	$83,445		SUM	($4,979)
	a.	Payback Period =Period at which Cumulative Cash Flow=NIL
		Payback Period of A=3+(115000/375000)	3.31	Years
		Payback Period of B= The investment is not paid back
		CHOOSE A
	b	NPV=Sum of Present Values of cash flows
		NPV of A	$83,445
		NPV of B	($4,979)
		CHOOSE : A
	c	Internal Rate of Return (IRR ) of A	27.94%	(Using IRR function of excel over the cash flows)
		Internal Rate of Return (IRR ) of B	-2.89%	(Using IRR function of excel over the cash flows)
		CHOOSE A
	d	Project A should be finally chosen
		Positive NPV creates wealth
		IRR is higher than the required return
			G27 X Fax =IRR(G10:14) A B C D E | F M Year G H I J K . Cumulative Present Value Cumulative Present Value Cash Flow A Cash Flow A of Cash Flow Cash Flow B Cash Flow B of Cash FlowB 0 ($175,000) ($175,000) ($175,000) ($20,000) ($20,000) ($20,000) 1 $10,000 ($165,000) $8,696 $10,000 ($10,000) $8,696 2 $25,000 ($140,000) $18,904 $5,000 ($5,000) $3,781 ($115,000) $16,438 $3,000 ($2,000) $1,973 4 $375,000 $260,000 $214,407 $1,000 ($1,000) $572 SUM $83,445 SUM ($4,979) a. Payback Period Period at which Cumulative Cash Flow=NIL Payback period of A=3+(115000/375000) 3.31 Years Payback period of B=The investment is not paid back CHOOSE A b NPV=Sum of Present Values of cash flows NPV of A NPV of B CHOOSE:A $83,445 ($4,979) Internal Rate of Return (IRR) of A 27.94%! (Using IRR function of excel over the cash flows) Intornalato of Rotun IPD ofe 2 990% Irine IRR function of ovcolour tho cach flow Clipboard Alignment Number Styles Cells Editing Font =IRR(J10:314) G28 : * ~ fic A B C D E M N Year G H I J K L Cumulative Present Value Cumulative Present Value Cash Flow A Cash Flow A of Cash Flow Cash Flow B Cash Flow B of Cash FlowB 0 ($175,000) ($175,000) ($175,000) $20,000) ($20,000) ($20,000) 1 $10,000 $165,000) $8,696 $10,000 $10,000) $8,696 2 $25,000 $140,000) $18,904 $5,000 ($5,000) $3,781 $25,000 ($115,000) $16,438 $3,000 ($2,000) $1,973 4 $375,000 $260,000 $214,407 $1,000 ($1,000) $572 SUM $83,445 SUM ($4,979) Payback period =Period at which Cumulative Cash Flow=NIL Payback period of A=3+(115000/375000) 3.31 Years Payback period of B=The investment is not paid back CHOOSE A NPV=Sum of Present Values of cash flows NPV of A NPV of B CHOOSE: A $83,445 ($4,979) Internal Rate of Return (IRR) of A Internal Rate of Return (IRR) of B (IRR) OF B 22.99! (Using IRR functior 27.94% (Using IRR function of excel over the cash flows) -2.89%! (Using IRR function of excel over the cash flows)