Question

Question 3

Consider the following two mutually exclusive projects. The required rate of return is 10%.

Part A: Calculate the NPV for each project.

Year	Project A	Project B
0	-$100,000	-$100,000
1	30,000	80,000
2	40,000	20,000
3	60,000	20,000

Part B: Calculate the IRR for each project.

Part C: Calculate the payback period for each project.

Part D: Suppose you were the manager deciding between these two projects. Would you prefer to use the payback period decision rule or the NPV decision rule? Why – use your solutions to parts A and C to support your answer?

Answer 1

PART A	NPV:
	PROJECT A:
	Year	Cash flow	PVIFA at 10%	PV at 10%
	0	-100000	1.00000	-100000
	1	30000	0.90909	27273
	2	40000	0.82645	33058
	3	60000	0.75131	45079
		NPV OF PROJECT A =		5409
	PROJECT B:
	Year	Cash flow	PVIFA at 10%	PV at 10%
	0	-100000	1.00000	-100000
	1	80000	0.90909	72727
	2	20000	0.82645	16529
	3	20000	0.75131	15026
		NPV OF PROJECT B =		4282
PART B	IRR:
	IRR is that discount rate which gives 0 NPV. I has to be found out by
	trial and error using different discount rates. The workings are given below:
	PROJECT A:
	Year	Cash flow	PVIFA at 13%	PV at 13%	PVIFA AT 12%	PV AT 12%
	0	-100000	1.00000	-100000	1.00000	-100000
	1	30000	0.88496	26549	0.89286	26786
	2	40000	0.78315	31326	0.79719	31888
	3	60000	0.69305	41583	0.71178	42707
				-542		1380
	IRR lies between 13% and 12%. The exact value can be found out by
	simple interporation as below:
	IRR = 12+1380/(1380+542) =			12.72%
	PROJECT B:
	Year	Cash flow	PVIFA at 13%	PV at 13%	PVIFA AT 14%	PV AT 14%
	0	-100000	1.00000	-100000	1.00000	-100000
	1	80000	0.88496	70796	0.87719	70175
	2	20000	0.78315	15663	0.76947	15389
	3	20000	0.69305	13861	0.67497	13499
				320		-936
	IRR lies between 13% and 14%. The exact value can be found out by
	simple interporation as below:
	IRR = 13+320/(320+936) =			13.25%
PART C:	PAYBACK PERIOD:
	PROJECT A:
	Year	Cash flow	Cumulative cash flow
	0	-100000	-100000
	1	30000	-70000
	2	40000	-30000
	3	60000	30000
	Payback period = 2+30000/60000 =			2.5 years
	PROJECT B:
	Year	Cash flow	Cumulative cash flow
	0	-100000	-100000
	1	80000	-20000
	2	20000	0
	3	20000	20000
	Payback period = 2.0 years
PART D:	DECISION:
	The results obtained above are tabulated below:
		Project A	Project B
	NPV	$      5,409	$           4,282
	IRR	12.72%	13.25%
	Paback period	2.5 years	2.0 years
	Payback favors Project B as it has lower payback.
	IRR also favors Project B as it has higher IRR.
	But NPV favors Project A which has higher NPV.
	For making a decision, I would prefer the NPV rule.
	The reason is that payback period has the following drawbacks:
	*It does not take into account the time value of money.
	*It does not consider the cash flows for the entire life of the
	project.
	As against this, the NPV has the following merits:
	*It considers the time value of money.
	*It considers all the cash flows during the life of the
	projects.
	*It gives directly the dollar addition to the present worth of
	the shareholders, which is the goal financial decision making.