Question

Question 1

The Horne Robinson Inc. has the following investment opportunities. Assume the discount rate the firm uses is 10%:

Year	Machine A ($15,000)	Machine B ($25,000)	Machine C ($65,000)
	Inflows:	Inflows:	Inflows:
1	$10,000	$12,000	$0
2	10,000	12,000	10,000
3	5,000	10,500	30,000
4	2,000	10,500	15,000
5	0	0	15,000

Required: Under NPV evaluation and assuming these machines are mutually exclusive, which machine(s) would Horne Robinson Inc. choose? Show all supporting calculations as required.

Question 2

A&B Enterprises is trying to select the best investment from among four alternatives. Each alternative involves an initial outlay of $100,000. Their cash flows follow:

Year	A	B	C	D
1	$10,000	$50,000	$25,000	$0
2	20,000	40,000	25,000	0
3	30,000	30,000	25,000	45,000
4	40,000	0	25,000	55,000
5	50,000	0	5,000	60,000

Required: Evaluate and rank each alternative based on a) payback period and b) net present value (use an 8% discount rate).

Answer 1

1. NPV of machine A

= - $ 15,000 + $ 10,000 / 1.10¹ + $ 10,000 / 1.10² + $ 5,000 / 1.10³ + $ 2,000 / 1.10⁴

= $ 7,477.97 Approximately

NPV of machine B

= - $ 25,000 + $ 12,000 / 1.10¹ + $ 12,000 / 1.10² + $ 10,500 / 1.10³ + $ 10,500 / 1.10⁴

= $ 10,886.89 Approximately

NPV of machine C

= - $ 65,000 + $ 10,000 / 1.10² + $ 30,000 / 1.10³ + $ 15,000 / 1.10⁴ + $ 15,000 / 1.10⁵

= - $ 14,637.07 Approximately

So the company shall choose machine B since it has the highest NPV.

2. Payback period is the period in which the initial investment is recovered by the future cash flows. The lower the payback period, the better it is.

Payback period of A

= $ 10,000 + $ 20,000 + $ 30,000 + $ 40,000

= $ 100,000

Hence the payback period of A is 4 years

Payback period of B

= 2 years + Unrecovered investment / Next years cash flow

= 2 years + $ 10,000 / $ 30,000

= 2.33 years Approximately

Payback period of C

= $ 25,000 + $ 25,000 + $ 25,000 + $ 25,000

= $ 100,000

Hence the payback period of C is 4 years

Payback period of D

= $ 0 + $ 0 + $ 45,000 + $ 55,000

= $ 100,000

Hence the payback period of D is 4 years

Hence the best project on the basis of payback period will be project B and after that all projects on the basis of payback period will have same rank since all the other projects have the same payback period i.e. 4 years.

b. NPV of project A

= - $ 100,000 + $ 10,000/1.08¹ + $ 20,000/1.08² + $ 30,000/1.08³ + $ 40,000/1.08⁴ + $ 50,000/1.08⁵

= $ 13,651.36 Approximately

NPV of project B

= - $ 100,000 + $ 50,000/1.08¹ + $ 40,000/1.08² + $ 30,000/1.08³

= $ 4,404.82 Approximately

NPV of project C

= - $ 100,000 + $ 25,000/1.08¹ + $ 25,000/1.08² + $ 25,000/1.08³ + $ 25,000/1.08⁴ + $ 5,000/1.08⁵

= - $ 13,793.91 Approximately

NPV of project D

= - $ 100,000 + $ 45,000/1.08³ + $ 55,000/1.08⁴ + $ 60,000/1.08⁵

= $ 16,984.08 Approximately

So as can be seen Project D is the best project in terms of NPV. The ranking of projects on the basis of NPV are as follows:

Project D

Project A

Project B

Project C

Feel free to ask in case of any query relating to this question