Question

X- Cell Limited is in the process of evaluating a project which will allow the firm to branch into a new product line. The projected cash flow for its new product line is as follows:

Year	Cash flows
0	(153,000)
1	78,000
2	67,000
3	49,000

               

1. Calculate the payback period for the project. What is the key drawback of the payback method of project appraisal?
2. If the required return is 11 percent, should the firm accept the project based on the IRR rule?
3. Suppose X-Cell uses the NPV decision rule. At a required return of 9 percent, should the firm accept the project? Will your decision change if the required was 15 percent and why?
4. Why is NPV considered to be a superior method of evaluating the cash flows from a project? Suppose the NPV for a period’s cash flows is computed to be $2500.00. What does this number represent to the firm’s shareholders?

Answer 1

Part A

Payback period =

Year	cash flow	cumulative Cash flow
0	(153000)	(153000)
1	78000	(75000)
2	67000	(8000)
3	49000	41000

Payback period = 2+(8000/49000)=2.16 years

The main drawback of payback period is that it ignores time value of money

Part B

IRR is calculated using Excel formula IRR

Write all cash flows in the rows in the following manner

(153000)

78000

67000

49000

Now apply formula ,

=irr(all cash flows)

Now press enter you will get answer as,

IRR = 14.02%

Yes, project should be accepted as IRR is greater than the required rate of return.

Part C

Npv = ((78000/(1.09^1))+(67000/(1.09^2))+(49000/(1.09^3)))-153000=12789

With 9% required rate of return, project should be accepted

Npv = ((78000/(1.15^1))+(67000/(1.15^2))+(49000/(1.15^3))-153000=-2294

With 15% required rate of return, project should be rejected.

The project with positive NPV should be accepted and one with negative NPV should be rejected.

Part D

The NPV is considered the best method as it considers the time value of money and it is simple and easy to calculate and understand. The project having NPV of 25000 implies that the present worth of cash inflows is more than cash outflows. The project is profitable. To shareholders this implies that this investment is worth undertaking and it will generate profits for them.