Question

You are considering the following two mutually exclusive projects. Both projects will be depreciated using straight-line depreciation to a zero book value over the life of the project. Neither project has any salvage value.

Year	Project(A)	Project (B)
0	-$30,000	-$30,000
1	13,000	5,000
2	11,000	5,000
3	9,000	5,000
4	7,000	5,000
5	0	5,000
6 7 8 9 10	0 0 0 0 0	5,000 5,000 5,000 5,000 5,000

The required rate of return is 10%.

(1). (4 points) What is the NPV for each of the projects? Which project should be accepted if NPV method is applied? Explain why.

(2). (4 points) What is the IRR for each of the projects? Which project should be accepted if IRR method is applied? Explain why.

(3). (4 points) What is the payback period for each of the projects? Which project should be accepted if payback period method is applied? Assume that the target payback period is 4 years. Explain why.

Answer 1

1). NPV for Project A = 2,452.02 (calculations shown in the table below)

NPV for Project B (using PV of annuity formula) = -30,000 + 5,000*(1-(1+10%)^-10)/10% = 722.84

Based on NPV, Project A should be accepted since it has higher NPV.

2). IRR for Project A = 14.16%

IRR for Project B = 10.56% (IRRs are calculated using IRR function in calculator or excel by entering the given cash flows)

Based on IRR, Project A should be accepted since it has greater IRR than Project B.

3). Payback period for Project A = 2.67 years (calculations shown in the table below)

Payback period for Project B (since annual cash inflow is same for all years) = initial investment/annual cash flow = 30,000/5,000 = 6 years

Based on the payback period, Project A should be accepted as it has a payback period of 2.67 years which is less than the target payback period of 4 years.

Calculations for Project A: