Question

X-treme Vitamin Company is considering two investments, both of which cost $14,000. The cash flows are as follows:

Year	Project A			Project B
1	$	16,000		$	14,000
2		6,000			5,000
3		4,000			9,000

a-1. Calculate the payback period for Project A and Project B. (Round your answers to 2 decimal places.)

	Payback Period Project A year(s) Project B year(s)

a-2. Which of the two projects should be chosen based on the payback method?
  

• Project A

• Project B

b-1. Calculate the net present value for Project A and Project B. Assume a cost of capital of 8 percent. (Do not round intermediate calculations and round your final answers to 2 decimal places.)

	Net Present Value Project A Project B

b-2. Which of the two projects should be chosen based on the net present value method?
  

• Project B

• Project A

c. Should a firm normally have more confidence in the payback method or the net present value method?

• Payback method

• Net present value method

Answer 1

a-1.Project A

Payback is computed using the below formula:

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

                             = $14,000/ $16,000

                            = 0.8750

The payback period is 0.88 years.

Project B

= $14,000/ $14,000

= 1 year.

a-2.Project A should be selected since it has the shortest payback period.

b-1.Project A

Net present value is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$14,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the cost of capital of 8%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The net present value of cash flows is $9,134.1767    $ 9,134.18.

Project B

Net present value is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$14,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the cost of capital of 8%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The net present value of cash flows is $10,394.1472       $10,394.15.

b-2.Project B should be chosen based on the net present value method since it has the highest net present value.

c.The firm should have more confidence in the net present value method. It takes into account the present value, that is money received today is worth more than money received tomorrow. In short it considers the time value of money.

Net present value gives company management a clearer picture of whether an investment will add value to the company. If the net present value has a positive value, it will add value and benefit the company’s shareholders.

Net present value helps to find out if the projected future cash flows cover the future cost of starting and running a business. It helps to understand how much an investment or project is worth. It gives them a clearer picture in making capital budgeting decisions.

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