Question

Consider the following two mutually exclusive projects: Year Cash Flow (Project I) Cash Flow (Project II)...

Consider the following two mutually exclusive projects:

Year Cash Flow (Project I) Cash Flow (Project II) 0 -\$12,300 -\$44,000 1 \$1,800 \$14,000 2 \$6,000 \$30,000 3 \$2,000 \$5,000 4 \$5,000 \$10,000 5 \$7,000 \$5,000

The required return is 10% for both projects. Assume that the internal rate of return (IRR) of Project I and Project II is 18% and 15%, respectively.

a) Which project will you choose if you apply the NPV criterion? Why?

b) Which project will you choose if you apply the payback criterion? Why?

c) Which project will you choose if you apply the IRR criterion? Why?

d) Based on the above answers, which project will you finally choose? Why?

1) As per NPV Criterio , Project 2 is choosen as it has more NPV than Project 1 as per below table.

 Project 1 Time Outlow/Inflow PVF@10% Present Value Amount Year 0 -12300 1.0000 -12300 Year 1 1800 0.9091 1636.363636 Year 2 6000 0.8264 4958.677686 Year 3 2000 0.7513 1502.629602 Year 4 5000 0.6830 3415.067277 Year 5 7000 0.6209 4346.449261 NPV 3559.187462
 Project 2 Time Outlow/Inflow PVF@10% Present Value Amount Year 0 -44000 1.0000 -44000 Year 1 14000 0.9091 12727.27273 Year 2 30000 0.8264 24793.38843 Year 3 5000 0.7513 3756.574005 Year 4 10000 0.6830 6830.134554 Year 5 5000 0.6209 3104.606615 NPV 7211.97633

Answe B) As per Payback period Project 2 is choosen as it has less payback period of 2 years as compared to project 1 which has high pack back period of 3 years 6 months

Project 1

 Time Inflow Cummulative Inflow Year 1 1800 1800 Year 2 6000 7800 Year 3 2000 9800 Year 4 5000 14800 Year 5 7000 21800
 As initial outflow of 12,300 is recovered between year 3 & 4 , Payback period is between year 3 & 4

= 3 + (12300-9800)/(14800-9800) * 12

= 3 Year 6 months.

Project 2

 Time Inflow Cummulative Inflow Year 1 14000 14000 Year 2 30000 44000 Year 3 5000 49000 Year 4 10000 59000 Year 5 5000 64000
 As initial outflow of 44,000 is recovered in year 2 , Payback period is year 2

On the basis of IRR project 1 should be choosen as it has the maximum gap between IRR & Required Return.

Project 1 = 18% -10 % = 8%

Project 2 = 15% -10 % = 5 %

As per overall analysis proct 2 should be choosen as it has higher NPV & Lower Payback period.

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