Question

Happy Valley Homes(HVH) manufactures and sells wood stoves to customers. HVH is thinking of investing in a new technology that will help them more efficiently manufacture and increase the quality of the wood stoves. There are two different tools, though, that HVH can invest in to do that. The information that HVH has given you is below: Option 1: Initial investment of 10,000 with cash flows of 2,000 in years 1 and 2, and cash flow of 6,000 in year 3, with no cash flows in year 4. Option 2: Initial investment of 5000 with cash flows of 1,000 in year 2, cash flows of 2,000 in year 3, and cash flows of 3,000 in year 4. The discount rate is 15%. HVH wants to know the following:

A. What is the payback period dscounted payback period for both options?

B. If you were to use a 4 year cut off for the discount payback, how would each project be affected?

C. What is the NPV of each project?

D. Which project, if any, would you recommend and why?

For each question, please show all workings and calculations as well as formulas

Answer 1

A.Option 1 :

(CF0 ) = ($10,000) Discounted cash flows

CF1 = $2,000 $1739.1304

CF2= $2,000 $1512.2873

CF3= $6,000 $3945.0974

The payback period is 3 years

The discounted payback period is : The initial investment amount cannot be recovered back during the tenure of the project.

CF0 = ($5,000)

CF1= $0

CF2= $1000 $756.1437

CF3= $2,000 $1315.0325

CF4= $3,000 $1715.2597

So, the payback period is : 3 + ($2,000)/ $3,000

= 3.67 Years

Discounted payback is :

= The initial investment cannot be recovered during the project.

B. The payback period of both of the projects is below 4, so it will not affect either of the two projects.

C. The NPV of project A is :

($10,000) + $2000/1.15 + $2000/1.15^2 + $6,000/1.15^3

= ($2803.4848)

Similarly,

The NPV of project B is : ($1213.5641)

D. Both of these projects have negative NPV's and as per the discounted payback method, the initial investment cannot be recovered for these projects. So, both of these projects should be rejected.