Question

A firm has a WACC of 8% and is deciding between two mutually exclusive projects. Project A has an initial investment of $63. The additional cash flows for project A are: year 1 = $20, year 2 = $39, year 3 = $67. Project B has an initial investment of $73.The cash flows for project B are: year 1 = $60, year 2 = $45, year 3 = $32.

a. What is the payback for project A? (Show your answer to 2 decimals.)

b. What is the payback for project B? (Show your answer to 2 decimals.)

c. Which project is preferred based on the payback method?

d. What is the NPV for project A? (2 decimals)

e. What is the NPV for project B? (2 decimals)

f. Which Project should be accepted? (Project A, Project B, Project A & B, Neither A or B)

Answer 1

a. Payback period formula = Years before recovery + Cost not covered in that year/ Cash flow for that year
=2+(63-20-39)/67 =2.06 years
b. Payback period formula = Years before recovery + Cost not covered in that year/ Cash flow for that year
=1+(73-60)/45 =1.29 years
c. Project B should be accepted based on payback method.
d. NPV of Project A =PV of Cash Flows-Initial Investment =20/1.08+39/1.08^2+67/1.08^3-63 =42.14
e. NPV of Project B =PV of Cash Flows-Initial Investment =60/1.08+45/1.08^2+32/1.08^3-73 =46.54
f. Project B should be accepted as NPV is higher