Question

Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 8 percent, and the maximum allowable payback for the project is 3.5 years Time Cash Flow 0 -5000 1 1200 2 2400 3 1600 4 1600 5 1400 6 1200 Evaluate this decision based on each of the following criteria: Payback IRR NPV In your write up, would you approve of this decision and why? Which method do you believe best evaluates this decision? Many companies have a preferred method, why is that? What things are not considered in this analysis, as in what are some possible intangible factors that might play into this?

Answer 1

Pay Back period is the period in which initial investment is recovered.

Year	Opening Bal	CF	Closing Bal
1	$ 5,000.00	$ 1,200.00	$ 3,800.00
2	$ 3,800.00	$ 2,400.00	$ 1,400.00
3	$ 1,400.00	$ 1,600.00	$    -200.00
4	$    -200.00	$ 1,600.00	$ -1,800.00
5	$ -1,800.00	$ 1,400.00	$ -3,200.00
6	$ -3,200.00	$ 1,200.00	$ -4,400.00

PBP = Year in which least +ve CB + [ CB in that year / CF in next year ]

= 2 + [ 1400 / 1600 ]

= 2 + 0.875

= 2.875 Years

NPV = PV of Cash Inflow - PV of Cash Outflows

Year	CF	PVF @8%	Disc CF
0	$ -5,000.00	1.0000	$ -5,000.00
1	$ 1,200.00	0.9259	$ 1,111.11
2	$ 2,400.00	0.8573	$ 2,057.61
3	$ 1,600.00	0.7938	$ 1,270.13
4	$ 1,600.00	0.7350	$ 1,176.05
5	$ 1,400.00	0.6806	$     952.82
6	$ 1,200.00	0.6302	$     756.20
NPV			$ 2,323.92

IRR is the Rate at which PV of Cash Inflows are equal to PV of Cash Outflows

Year	CF	PVF @22%	Disc CF	PVF @23%	Disc CF
0	$ -5,000.00	1.0000	$ -5,000.00	1.0000	$ -5,000.00
1	$ 1,200.00	0.8197	$     983.61	0.8130	$     975.61
2	$ 2,400.00	0.6719	$ 1,612.47	0.6610	$ 1,586.36
3	$ 1,600.00	0.5507	$     881.13	0.5374	$     859.81
4	$ 1,600.00	0.4514	$     722.24	0.4369	$     699.04
5	$ 1,400.00	0.3700	$     518.00	0.3552	$     497.28
6	$ 1,200.00	0.3033	$     363.93	0.2888	$     346.54
NPV			$        81.38		$      -35.36

IRR = Rate at which least +ve NPV + [ NPV at that Rate / Change in NPV due to 1% inc in disc Rate } * 1%

= 22% + [ 81.38 / 116.74 ] * 1%

= 22% + 0.7%

= 22.70%

Project can be selected as Payback period is lesser than desired Payback period and NPV>0 and IRR > Cost of Capital.