Question

 

You are considering the following two mutually exclusive projects. Both projects will be depreciated using straight-line depreciation to a zero book value over the life of the project. Neither project has any salvage value.

Year	Project(A)	Project (B)
0	-$30,000	-$30,000
1	13,000	5,000
2	11,000	5,000
3	9,000	5,000
4	7,000	5,000
5	0	5,000
6 7 8 9 10	0 0 0 0 0	5,000 5,000 5,000 5,000 5,000

The required rate of return is 10%.

(1). (4 points) What is the NPV for each of the projects? Which project should be accepted if NPV method is applied? Explain why.

(2). (4 points) What is the IRR for each of the projects? Which project should be accepted if IRR method is applied? Explain why.

(3). (4 points) What is the payback period for each of the projects? Which project should be accepted if payback period method is applied? Assume that the target payback period is 4 years. Explain why.

(4). (4 points) What is the discounted payback period for each of the projects? Which project should be accepted if discounted payback period method is applied? Assume that the target discounted payback period is 4 years. Explain why.

Explain why.

(5). (4 points) What is the profitability index for each of the projects? Which project should be accepted if profitability index method is applied? Explain why.

(6). (4 points) What is the average accounting return (AAR) for each of the projects, assuming that cash flows occurring after year 0 are net income? Which project should be accepted if AAR method is applied? Also, assume that the target AAR is 20%.

(7). (4 points) Define and find the crossover rate.

(8). (7 points) Sketch the NPV profile. Plot all the relevant coordinates (i.e., the points on the x and y axis; and the cross-over rate) on the graph.

Answer 1

Solution:-

To Calculate NPV of the Project-

NPV of the Project is accepted when it is greater than or equal to zero. In Mutually Exclusive project project is accepted whose NPV is higher. Hence, Accept Project A.

To Calculate IRR of the Project-

IRR is the rate of return at which NPV of the Project is Zero. IRR is higher the Better. Hence, Accept Project A.

To Calculate Payback Period -

Project A -

Payback Period
Year	Cash Flow	Cummulative Cash Flow
0	-30000
1	13000	13000
2	11000	24000
3	9000	33000
4	7000	40000

Payback Period =

Payback Period =

Payback Period = 2.67 years

Project B-

Payback Period =

Payback Period =

Payback Period = 6 years

Payback Period is the amount of time which project can take to recover its initial Investment. Payback Period is lower the Better. Hence, Accept Project A.