Question

XYZ Company has two good businesses. Each has an initial investment of $ 25,000 with each cash flow as follows:

Year	Business 1 Cash Flow	Business 2 Cash Flow
1	7,500	7,500
2	7,000	7,500
3	6,000	7,500
4	5,000	7,500
5	3,500	7,500

If the cost of capital is 12.5%, calculate:

A. Payback Period and NPV

B. In your opinion, which business is better chosen? Business 1 and Business 2? And Why?

Answer 1

A.Business 1

Payback period= full years until recovery + unrecovered cost at the start of the year/cash flow during the year

                             = 3 years + ($25,000 - $20,500)/ $5,000

                             = 3 years + $4,500/ $5,000

                             = 3 years + 0.90

                             = 3.90 years.

Net present value is solved here using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$1,000,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter cost of capital of 12.5%.
• Press the down arrow and CPT buttons to get the net present value.

The net present value is $3,524.75.

Business 2

Payback period= full years until recovery + unrecovered cost at the start of the year/cash flow during the year

                             = 3 years + ($25,000 - $22,500)/ $7,500

                             = 3 years + $2,500/ $7,500

                             = 3 years + 0.33

                             = 3.33 years.

Net present value is solved here using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$1,000,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter cost of capital of 12.5%.
• Press the down arrow and CPT buttons to get the net present value.

The net present value is $1,704.26.

B.According to me, Business 1 is better chosen since it has the highest net present value.

In case of any query, kindly comment on the solution.