Question

3. Henry is trying to select the best investment from among 3 alternatives. Each alternative involves an initial outlay of 200,000$. Their cash flows returns for each project are as follows (in $):
   
   year           project A         project B          project C
   1                110,000           150,000           0
   2               120,000           140,000           0
   3                130,000           130,000           145,000
   4                140,000           0                      155,000
   5                150,000           0                      160,000
   

a) Evaluate and rank each alternative based on the payback period? What are the general problems associated with using this method?

b) Evaluate and rank each alternative based on Net Present Value (use a 5% discounted rate). What are the problems using the NPV?

Answer 1

Answer a:

Year	Particulars	Cash flow returns
		Project A	Cumulative return for Project A	Project B	Cumulative return for Project B	Project C	Cumulative return for Project C
1		$                                                    1,10,000.00	$                                            1,10,000.00	$                                                    1,50,000.00	$                                            1,50,000.00	$                                                                           -	$                                                                                   -
2		$                                                    1,20,000.00	$                                            2,30,000.00	$                                                    1,40,000.00	$                                            2,90,000.00	$                                                                           -	$                                                                                   -
3		$                                                    1,30,000.00	$                                            3,60,000.00	$                                                    1,30,000.00	$                                            4,20,000.00	$                                                        1,45,000.00	$                                                                1,45,000.00
4		$                                                    1,40,000.00	$                                            5,00,000.00	$                                                                       -	$                                            4,20,000.00	$                                                        1,55,000.00	$                                                                3,00,000.00
5		$                                                    1,50,000.00	$                                            6,50,000.00	$                                                                       -	$                                            4,20,000.00	$                                                        1,60,000.00	$                                                                4,60,000.00
Initial Outflow	$                                                                                            2,00,000.00
Payback period
	Formula:
	=Year + (Cumulative return greater than initial outflow-initial outflow)/(Cumulative return greater than initial outflow-Cumulative return for the previous year)	=1 + (230000-200000)/(230000-110000)	1.3	=1 + (290000-200000)/(290000-150000)	1.6	=1 + (300000-200000)/(300000-145000)	3.6
Rank			I		II		III

Answer : On the basis of Payback period the rank is determined on the basis of time period within which the outflow will be cleared. Accordingly, Project A is taking the least time so it is ranked first. But the drawback of this method is that it does not consider the future returns of the project.

Answer b:

Calculation of NPV
Year	Discounting factor @5%	Project A	PV = Return Project A * discounting factor	Project B	PV = Return Project B * discounting factor	Project C	PV = Return Project C * discounting factor
1	0.95	$                                                    1,10,000.00	$                                            1,04,761.90	$                                                    1,50,000.00	$                                            1,42,857.14	$                                                                           -	$                                                                                   -
2	0.91	$                                                    1,20,000.00	$                                            1,08,843.54	$                                                    1,40,000.00	$                                            1,26,984.13	$                                                                           -	$                                                                                   -
3	0.86	$                                                    1,30,000.00	$                                            1,12,298.89	$                                                    1,30,000.00	$                                            1,12,298.89	$                                                        1,45,000.00	$                                                                1,25,256.45
4	0.82	$                                                    1,40,000.00	$                                            1,15,178.35	$                                                                       -	$                                                               -	$                                                        1,55,000.00	$                                                                1,27,518.88
5	0.78	$                                                    1,50,000.00	$                                            1,17,528.92	$                                                                       -	$                                                               -	$                                                        1,60,000.00	$                                                                1,25,364.19
Total Present value			$                                            5,58,611.60		$                                            3,82,140.16		$                                                                3,78,139.52
Initial outflow			$                                            2,00,000.00		$                                            2,00,000.00		$                                                                2,00,000.00
NPV(net present value)	(Present value - Initial outflow)		$                                            3,58,611.60		$                                            1,82,140.16		$                                                                1,78,139.52
Rank			I		II		III

Answer: The NPV of Project A is the highest since it is providing the highest Net present value of $ 358611.60. NPV drawback is it takes a discounting factor by which return is discounted. NPV is not successful when comparing projects with different investment amounts.