Question

Novell, Inc., has the following mutually exclusive projects.

Year Project A. Project B

__ __

0 22, 000 25,000

1 13,000 14,000

2 9,500 10,500   

3 3,100 9,500

a-1. Calculate the payback period for each project. (Do not round intermediate calculations and round your answers to 3 decimal places, e.g. 32.161.)

Project A. _____ years

Project B ______ years

a-2. If the company's payback period is two years, which, if either, of these projects should be chosen? (Choose the correct answer)

Project A

Project B

Both Projects

Neither project

b-1. What is the NPV for each project if the appropriate discount rate is 16 percent? (A negative answer should be indicated by a minus sing. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

Project A. ______

Project B. _______

b-2. Which, if either, of these projects should be chosen if the appropriate discount rate is 16 percent? (Choose the correct answer)

Project A

Project B

Both projects

Neither project

Answer 1

Cash flows:

Project A:
Year 0: -$22000
Year 1: $13000
Year 2: $9500
Year 3: $3100

We have taken negative sign in the year 0 cash flow as it is a cash outflow (investment made at the beginning).

Project B:
Year 0: -$25000
Year 1: $14000
Year 2: $10500
Year 3: $9500

Part a-1: Payback period for each project:

Cumulative cash flows for project A:
Year 0: -22000
Year 1: 13000-22000=-9000
Year 2: 9500-9000=500
Year 3: 3100

Payback period=Full years until recovery + (Unrecovered cost at the beginning of last year)/(Cash flow during last year)

=1+9000/9500=1.947368421 or 1.947 years (Rounded to three decimal places)

Cumulative cash flows for project B:
Year 0: -25000
Year 1: 14000-25000=-11000
Year 2: 10500-11000=-500
Year 3: 9500-500=9000

Payback period=2+500/9500=2.052631579 or 2.053 (Rounded to three decimal places)

Part a-2:
Answer: Project A should be chosen because the payback period is less than 2.
Given that the projects are mutually exclusive projects. Mutually exclusive projects are a set of projects out of which only one project can be selected.
Given that the company's payback period is two years, so the project with payback period less than 2 (that is project A) should be selected.

Part b-1:

Given that the discount rate is 16%
NPV=-Initial investment + Present value of future cash flows.
NPV for project A with the following cash flows:
Year 0: -$22000
Year 1: $13000
Year 2: $9500
Year 3: $3100
NPV=-22000+13000/(1+16%)^1+9500/(1+16%)^2+3100/(1+16%)^3
=-22000+13000/1.16+9500/1.3456+3100/1.560896
NPV of project A=-1747.017098 or -$1747.02 (Rounded to two decimal places)

NPV for project B with the following cash flows:
Year 0: -$25000
Year 1: $14000
Year 2: $10500
Year 3: $9500
NPV=-25000+14000/(1+16%)^1+10500/(1+16%)^2+9500/(1+16%)^3
=-25000+14000/1.16+10500/1.3456+9500/1.560896
NPV of project B=958.4238796 or $958.42 (Rounded to two decimal places)

Part b-2:
Answer: Project B should be chosen because of positive NPV of $958.42.