Question

7.5 Consider the following two mutually exclusive projects: Year Cash Flow (A) Cash Flow (B) -$200,000 $20,000 1 15,000 12,000 30,000 11,000 3 32,000 10,000 4 400,000 9,000 Whichever project you choose, if any, you require a 15 percent return on your investment. a. (2 points) If you apply the payback criterion, which investment will you choose? Why? b. (2 points) If you apply the NPV criterion, which investment will you choose? Why? c. (2 points) If you apply the IRR criterion, which investment will you choose? Why? (note the IRR of the two projects are 26.96% and 40.60%, you just have to show me which one is which) d. (2 points) If you apply the profitability index criterion, which investment will you choose? Why? e. (2 points) Based on your answers in (a) through (d), which project will you finally choose? Why?

Answer 1

a. Payback period formula = Years before recovery + Cost not covered in that year/ Cash flow for that year
Pay back Period of A =3+(200000-15000-30000-32000)/400000 =3.3075 years
Pay back Period of B =1+(20000-12000)/11000 =1.73 years
If we apply payback Period Project B would be chosen.

b. NPV of Project A =PV of Cash flows -Initial Investment =15000/(1+15%)+30000/(1+15%)^2+32000/(1+15%)^3+400000/(1+15%)^4-200000=85,469.61
NPV of Project B =PV of Cash flows -Initial Investment =12000/(1+15%)+11000/(1+15%)^2+10000/(1+15%)^3+9000/(1+15%)^4-20000=10,473.30
Project A must be chosen based on NPV

c.Using financial calculator
CF0=-200000;CF1=15000;CF2=30000;CF3=32000;CF4=400000;CPT IRR =26.96%
IRR of Project A =26.96%

Using financial calculator
CF0=-20000;CF1=12000;CF2=11000;CF3=10000;CF4=9000;CPT IRR =40.60%
IRR of Project B =40.60%

Based on IRR project B must be chosen.

d.Profitability index =1+NPV/Investment
PI of A =1+85,469.61/200000=1.43
PI of B =1+10,473.30/20000 =1.52
Based on Profitability index Project B must be selected.

e.Based on all criteria Project A must be chosen because NPV of A is higher.