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

Step-1:Calculation of payback period
Payback period is the time within cost of project is recovered back.
Payback period is calculated as follows:
	Business 1			Business 2
Year	Cash flows	Cumulative Cash flows		Cash flows	Cumulative Cash flows
0	$          -25,000	$     -25,000		$          -25,000	$         -25,000
1	$              7,500	$     -17,500		$              7,500	$         -17,500
2	$              7,000	$     -10,500		$              7,500	$         -10,000
3	$              6,000	$        -4,500		$              7,500	$           -2,500
4	$              5,000	$             500		$              7,500	$             5,000
5	$              3,500	$         4,000		$              7,500	$           12,500
Payback period of Business 1			=	3+(4500/5000)	=	3.90 Years
Payback period of Business 2			=	3+(2500/7500)	=	3.33 Years
Step-2:Calculation of NPV
			Business 1			Business 2
Year	Discount factor		Cash flows	Present value of cash flows		Cash flows	Present value of cash flows
a	b=1.125^-a		c	d=b*c		e	f=b*e
0	1.0000		$-25,000	$          -25,000		$-25,000	$ -25,000
1	0.8889		$    7,500	$              6,667		$    7,500	$     6,667
2	0.7901		$    7,000	$              5,531		$    7,500	$     5,926
3	0.7023		$    6,000	$              4,214		$    7,500	$     5,267
4	0.6243		$    5,000	$              3,121		$    7,500	$     4,682
5	0.5549		$    3,500	$              1,942		$    7,500	$     4,162
	NPV			$            -3,525			$     1,704
Conclusion:
Payback period of Business 2 is less than Business 1.It means Business 2 will return back initial investment faster than Business 1.
Further NPV of Business 2 is positive whereas Business 1 has negative NPV.It means we are generating some money if we make investment in Business 2.
So, on the basis of above statistics, Business 2 is better then Business 1.