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?

Homework Answers

Answer #1

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

Answer c

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 %

Answer D

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

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