Question

Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 8 percent, and the maximum allowable payback for the project is 3.5 years

Time	Cash Flow
0	-5000
1	1200
2	2400
3	1600
4	1600
5	1400
6	1200

Evaluate this decision based on each of the following criteria:

• Payback
• IRR
• NPV

In your write up, would you approve of this decision and why? Which method do you believe best evaluates this decision? Many companies have a preferred method, why is that? What things are not considered in this analysis, as in what are some possible intangible factors that might play into this?

Show Work in excel

Answer 1

Payback Period Year Cash inflow 1200 2400 1600 1600 1400 1200 Project A 1 Invesment amount 2 inflow from 1 to 2 3 Balance recovered from Year 3(5000-3600) 5000 3600 1400 4 Payback Period(2 Years+1400/1600) 2.94 Years

Net Present Value Year Cash inflow Present Annuity factor@8% Present Value A*B 1.000 0.926 0.857 0.794 -5000 1200 2400 1600 1600 1400 1200 Net Present Value 0.735 -5000.00 1111.11 2057.61 1270.13 1176.05 952.82 756.20 2324 0.681 0.630

Internal rate of return (i,e rate at which discounted cash inflows equal to cash outflows) Year Cash Flows Use this formula in MS excel -5000 IRR Fomula=IRR(C20:C26) 1200 2400 1,e IRR 23% 1600 1600 1400 1200 Conclusion: As NPV is positive hence investing decision is advisable Net Present Value Method is the best capital budgeting method. Reasons: NPV gives importance to the time value of money.