Question

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?

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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1
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390,000
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