Question

All techniques, conflicting rankings Nicholson Roofing Materials, Inc., is considering two mutually exclusive projects, each with an initial investment of $160,000. The company's board of directors has set a 4-year payback requirement and has set its cost of capital at 10%. The cash inflows associated with the two projects are shown in the following table: 0 Data Table 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. a. The payback period of project Ais L years. (Round to two decimal places.) (Click on the icon located on the top-right corner of the data table below in order to copy its contents into a spreadsheet.) Year Cash inflows (CF) Project A Project B $50,000 $75,000 $50,000 $50,000 $50,000 $40,000 $50,000 $40,000 $50,000 $40,000 $50,000 $40,000

Answer 1

a]

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period of A  = 3 + (cash flow required in year 4 for cumulative cash flows to equal zero / year 4 cash flow) = 3 + ( $10,000 / $50,000) = 3.20 years

Payback period of B  = 2 + (cash flow required in year 3 for cumulative cash flows to equal zero / year 3 cash flow) = 2 + ( $35,000 / $40,000) = 2.875 years

A B C D LE Cumulative Cumulative Cash Flow-Cash Flow - Cash Flow - Cash Flow - 1 Year 0 ($160,000) ($160,000) ($160,000) 1 $50,000 $75,000 ($110,000) 2 $50,000 $50,000 ($60,000) $50,000 $40,000 ($10,000) $50,000 $40,000 $40,000 $50,000 $40,000 $90,000 $50,000 $40,000 $140,000 ($160,000) ($85,000) ($35,000) $5,000 $45,000 $85,000 $125,000

A 1 Year 20 3 1 4 2 B с Cumulative Cumulative Cash Flow - Cash Flow - Cash Flow - A A Cash Flow - BA - 160000 -160000 =B2 =C2 50000 75000 =D2+B3 =E2+C3 50000 50000 =D3+B4 =E3+04 50000 40000 =D4+B5 =E4+C5 50000 40000 =D5+B6 =E5+C6 50000 40000 =D6+B7 =E6+C7 50000 40000 =D7+B8 =E7+C8 5 3 64 75 8 6

Rank 1 - Project B - shorter payback period.

Rank 2 - Project A - longer payback period.

Both the projects have a payback period less than the maximum payback period of 4 years.

b]

NPV is calculated using NPV function in Excel.

Rank 1 - Project A - higher NPV

Rank 2 - Project B - lower NPV

- fx =NPV(10%,B3:38)+B2 F G H A B C Cash Flow - Cash Flow 1 Year A 0 ($160,000) ($160,000) 1 $50,000 $75,000 2 $50,000 $50,000 3 $50,000 $40,000 $50,000 $40,000 7 5 $50,000 $40,000 8 6 $50,000 $40,000 9 NPV | $57,763 $54,293

fax =NPV(10%,C3:C8)+C2 F G H А в Cash Flow - Cash Flow 1 Year A 2 0 ($160,000) ($160,000) 1 $50,000 $75,000 2 $50,000 $50,000 3 $50,000 $40,000 4 $50,000 $40,000 $50,000 $40,000 $50,000 $40,000 9 NPV $57,763 $54,293

c]

IRR is calculated using IRR function in Excel.

Rank 1 - Project B - higher IRR

Rank 2 - Project a - lower IRR

B10 AB fac =IRR(B2:38) F G C Cash Flow - Cash Flow 1 Year A 2 0 ($160,000) ($160,000) 3 1 $50,000 $75,000 2 $50,000 $50,000 3 $50,000 $40,000 $50,000 $40,000 5 $50,000 $40,000 6 $50,000 $40,000 9 NPV $57,763 $54,293 10 IRR 21.57% 22.62% 8

c10 A f C x =IRR(C2:C8) F G B Cash Flow - Cash Flow 1 Year A 2 O ($160,000) ($160,000) 1 $50,000 $75,000 2 $50,000 $50,000 $50,000 $40,000 4 $50,000 $40,000 5 $50,000 $40,000 6 $50,000 $40,000 9 NPV $57,763 $54,293 10 IRR 21.57% 22.62% 7 11

d]

Both the projects have a payback period less than the maximum payback period of 4 years.

The IRR and NPV rankings are conflicting. In this case, the project with higher NPV should be chosen because a project with higher NPV creates more value for investors.

Project A is recommended.