Question

The CFO of a major corporation is trying to decide on what project to pursue using different investment criteria Net Present Value (NPV), Payback Period, Discounted Payback Period, Internal Rate of Return (IRR), and the Profitability Index (PI). The CFO has four projects to choose between: Project W (which is a strip mine -see problem 6), Project X, Project Y, and Project Z. Additional information about each project is summarized below You can use the workspace provided to help answer questions 6-11 appropriate dscom rene is 60% Project W 200 S X Costs $8C0M today (T- appropriate dscom rote it 60% YEAR 10 appropriate dscourt rate is 8.0% YEAR Project Y appropriate dacourt farte İl 7.0% Project Z

6. Project W is a strip mine which requires you to clean up environmental damage when retiring the mine; this is why cash flows in year 5 and year 6 are negative. The NPV of Project W is closest to:

1. $442

2. $600

3. $640

4. $1440

5. $1500

7. The CFO decides to pursue only one project, but the project is required to have an NPV greater than or equal to $500M. If more than one project satisfies this criteria, the CFO will make the decision to pick the project with the highest PI. Which project would you choose:

1. W

2. X

3. Y

4. Z

5. None of the projects

8. For this problem only, assume the CFO only has $2000 to invest today, the CFO cannot borrow any additional funds, and any remaining funds (not invested in the projects) earns 0.0% interest. The CFO wants to maximize NPV by pursuing as many projects possible. Which project (s) would the CFO choose:

1. W,X,Y,Z

2. W&Y

3. W&Z

4. X & Z

5. Y & Z

9. The IRR of Project X is closest to:

1. 10.0%

2. 12.5%

3. 15.0%

4. 20.0%

5. 25.0%

10. For this problem only, assume the CFO only has $2000 to invest today, the CFO cannot borrow any additional funds, and any remaining funds (not invested in the projects) earns 0.0% interest. The CFO is considering picking the project with the highest IRR. You are hired as a consultant; how would you advise the CFO to proceed?

1. Pick Project W because it has the highest IRR

2. Pick Project X because it has the highest IRR

3. Pick Project Y because it has the highest IRR

4. Don’t use IRR to rank mutually exclusive projects, use a different criteria to pick the best project

5. Don’t pick Project W because it has unconventional cash flows; instead, Pick Project X because it has the

   second highest IRR

11. For Project X, the discounted payback period is about _____ longer than the payback period.

1. 3 months

2. 4 months

3. 6 months

4. 7 months

5. 10 months

Answer 1

The capital investment evaluation criteria –

1.         Payback Period (PBP)

            One of the most popular and widely recognized traditional methods of evaluating capital investment proposal is the payback period. It is the number of years it takes a firm to recover its original investment from net cash flows. The payback period of an investment is the length of time required for the cumulative total net cash flows from the investment to equals to total initial cash outlays.

General Rule – Earlier the better.

2.         Net Present Value (NPV)

            It is the Present value of the projects net cash flows discounted at the company’s cost of capital to the time of the initial capital outlay, minus that initial capital outlay.

General Rule – Higher the NPV, better it is.

3.         Internal rate of Return (IRR)

            IRR is the rate of return at which present value of cash inflows equals to present value of cash outflows.

General Rule – Higher the better.

4.         Profitability Index (PI)

            It is ratio of present value of cash inflows and outflows.

General Rule – Higher the better.

5.         Discounted Payback period

            It refers to the period to the period within which the present value of cash inflows completely recovers the present value of cash outflows.

General rule – Earlier the better.

Computation of NPV,IRR,PI,PBP for all Projects W,X,Y,Z

Project-W

Formula reference -

Project-X

formula reference -

Project Y & Z

formula reference-