Question

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

                YEAR                                    A                                                         B  

                1                                        30,000                                                       0   

                2                                        30,000                                                 25,000

                3                                        30,000                                                 35,000           

                4                                        30,000                                                 45,000

                5                                        30,000                                                 50,000

Evaluate and rank each alternative based on

        a.     payback period

        b.     net present value (use a 10% discount rate) and

        c.     internal rate of return.

Answer 1

a. Payback Period of Project A = Years before recovery + Cost not covered in that year/ Cash flow for that year =
=3+(100000-30000-30000-30000)/30000 =3.33
Payback Period of Project B= Years before recovery + Cost not covered in that year/ Cash flow for that year =
=3+(100000-0-25000-35000)/45000 =3.89
Project A is better than Project B on the basis of Payback period.

b. NPV of Project A =PV of Cash Flows -Investments =30000*(1-(1+10%)^-5)/10%-100000=13723..60
NPV of Project B  =PV of Cash Flows -Investments =0+25000/1.1+35000/1.1^2+45000/1.1^3+50000/1.1^5-100000=8738.85
Project A is better than Project B on the basis of NPV.

c. Using Financial Calculator

Project A CF0=-100000;CF1=30000;CF2=30000;CF3=30000;CF4=30000;CF5=30000;CPT IRR =15.24%

Project B CF0=-100000;CF1=0;CF2=25000;CF3=35000;CF4=45000;CF5=50000;CPT IRR =12.55%
Project B IRR is higher than Project A hence Project B is better