Question

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

  

Year		Project A		Project B
0		–$25,000		–$28,000
1		14,500		15,500
2		11,000		12,000
3		3,400		11,000

  

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.)

      

a-2.	If the company's payback period is two years, which, if either, of these projects should be chosen?
	Project A Project B Both projects Neither project

  

b-1.	What is the NPV for each project if the appropriate discount rate is 17 percent? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

      

b-2.	Which, if either, of these projects should be chosen if the appropriate discount rate is 17 percent?
	Project A Project B Both projects Neither project

Answer 1

a.1. Payback period of project A is computed as follows:

Year	Project A Cash Flows	Cumulative Project A Cash Flows
0	- $ 25,000	- $ 25,000
1	$ 14,500	- $ 10,500 ( - $ 25,000 + $ 14,500 )
2	$ 11,000	$ 500 ( - $ 10,500 + $ 11,000 )

Payback period is the period in which the project initial investment is recovered.

So the project A payback period is lying between year 1 and year 2 and is computed as shown below:

1 year + Balance cost to be recovered after year 1 / Year 2 cash flows

1 year + $ 10,500 / $ 11,000

= 1.955 years approximately.

Payback period of project B is computed as follows:

Year	Project B Cash Flows	Cumulative Project B Cash Flows
0	- $ 28,000	- $ 28,000
1	$ 15,500	- $ 12,500 ( - $ 28,000 + $ 15,500 )
2	$ 12,000	- $ 500 ( - $ 12,500 + $ 12,000 )
3	$ 11,000	$ 10,500 ( - $ 500 + $ 11,000 )

Payback period is the period in which the project initial investment is recovered.

So the project B payback period is lying between year 2 and year 3 and is computed as shown below:

2 years  + Balance cost to be recovered after year 2 / Year 3 cash flows

2 years + $ 500 / $ 11,000

= 2.045 years approximately.

a-2. If the company's payback period is two years, Project A should be chosen, since project A payback period is less than 2 years.

b-1. NPV of project A at discount rate of 17% is computed as follows:

= - $ 25,000 + $ 14,500 / ( 1 + 0.17 )¹ + $ 11,000 / ( 1 + 0.17 )² + $ 3,400 / ( 1 + 0.17 )³

= - $ 2,448.33 Approximately.

NPV of project B at discount rate of 17% is computed as follows:

= - $ 28,000 + $ 15,500 / ( 1 + 0.17 )¹ + $ 12,000 / ( 1 + 0.17 )² + $ 11,000 / ( 1 + 0.17 )³

= $ 882.10 Approximately.

b-2. Since the NPV of project B is positive, hence project B should be accepted.

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