Question

Question 2 Year DKW Inc., has two projects offering Project X and Project Y. They are mutually exclusive, and both require $350,000 for investment. The cost of capital is 10%. The following table are expected cash flow Project X ($) Project Y ($) 90,000 180,000 90,000 120,000 90,000 60000 90,000 50,000 90,000 50,000 90,000 2.1 Calculate Project X's the internal rate of return (IRR). Use formula of Time Value of Money to illustrate 23 Calculate payback period of both projects, 2.2 Calculate PI of both projects 2.4 Calculate NPV of both projects. Use formula of Time Value of Money to illustrate. 2.6 If payback criteria are cutoff at 2 years, which project should be selected? 2.5 Which project should be selected? Why?

Answer 1

2.1 The IRR of project X is :

Using the time value of money formula:

($350,000) + 90,000/(1+ IRR)^1 + 90,000/(1+ IRR)^2 + ......90,000/(1+ IRR)^6 = 0

= 9%

Similarly, the IRR for project B is :

= 13.41%

2.4 NPV for project A is :

( $350,000) + $90,000/(1.1)^1 + 90,000/(1.1)^2 + ....90,000/(1.1)^6

= $41,973.463

The NPV of this project is :

($350,000) + 180,000/(1.1)^1 + 120,000/(1.1)^2 + 60,000/(1.1)^3 + 50,000/(1.1)^4 + 50,000/(1.1)^5

= $23,0855.5443

2.3 Payback period is :

= 3 + $80,000/$90,000

= 3.8889 years

= 3.89 years

Similarly the payback period for project B is :

= 2 + $50,000/$60,000

= 2.83 years

2.2 the profitability index is :

= NPV + initial investment/ initial investment

= $41.973.463 + 350,000/$350,000

= 1.12

Similarly for project B is :

= $230,855.5443+ 350,000/350,000

= 1.66

2.6 If the payback period cut off is 2 years, neither of the projects should be accepted, as both the projects has a payback period of more than 2 years.

2.5 The project with the highest NPV should be selected ,so we should select project A. The reinvestment rate assumption is more realistic in the case of NPV and not IRR so the results obtained from NPV is the most accurate result,so we give priority to the NPV method over all the other methods for evaluating capital budgeting projects.