Question

Medical Technology Enterprises is trying to select the best investment from among four alternatives. Each alternative involves an initial outlay of $100,000. and the company’s cost of capital (WACC) is 8%. Their future cash flows follow:

Evaluate and rank each alternative based on payback period, net present value, and internal rate of return.

Year	Alternative A ($)	Alternative B (S)	Alternative C ($)
1	10,000	50,000	25,000
2	20,000	40,000	25,000
3	30,000	30,000	25,000
4	40,000	0	25,000
5	50,000	0	25,000

Answer 1

Payback period:

Year	Alternative A ($)	Cumulative cash flows	Alternative B (S)	Cumulative cash flows	Alternative C ($)	Cumulative cash flows
1	$      10,000	$        10,000	$      50,000	$        50,000	$      25,000	$        25,000
2	$      20,000	$        30,000	$      40,000	$        90,000	$      25,000	$        50,000
3	$      30,000	$        60,000	$      30,000	$      120,000	$      25,000	$        75,000
4	$      40,000	$      100,000	$              -	$      120,000	$      25,000	$      100,000
5	$      50,000	$      150,000	$              -	$      120,000	$      25,000	$      125,000

Alterative A:

Cumulative cash flow reached $100,000 exactly at the end of 4^th year. Therefore payback period is 4 years.

Alterative B:

Cumulative cash flow exceeds $100,000 of initial investment at the end of third year. Therefore, payback period is between 2^nd and 3^rd year is computed as follows.

Payback period = 2 + ($10,000/$30,000) * 12 months

                                = 2 + (1/3) * 12 months

                                = 2 year 4 months.

Therefore payback period is 2 years and 4 months.

Alterative C:

Cumulative cash flow reached $100,000 exactly at the end of 4^th year. Therefore payback period is 4 years.

Therefore payback period is 4 years.

NPV calculations:

Alternative A ($)

Year	Alternative A ($)	Discount factor @ 8%	Cash flows
1	$      10,000	0.925925926	$                9,259.26
2	$      20,000	0.85733882	$              17,146.78
3	$      30,000	0.793832241	$              23,814.97
4	$      40,000	0.735029853	$              29,401.19
5	$      50,000	0.680583197	$              34,029.16
			$           113,651.36
		Less: Initial investment	$100000
			$              13,651.36

Alternative B ($)

Year	Alternative B (S)	Discount factor @ 8%	Cash flows
1	$        50,000	0.925925926	$   46,296.30
2	$        40,000	0.85733882	$   34,293.55
3	$        30,000	0.793832241	$   23,814.97
4	$                 -	0.735029853	$                   -
5	$                 -	0.680583197	$                   -
			$ 104,404.82
		Less: Initial investment	$100000
			$      4,404.82

Alternative C ($)

Year	Alternative C ($)	Discount factor @ 8%	Cash flows
1	$25,000	0.925925926	$   23,148.15
2	$25,000	0.85733882	$   21,433.47
3	$25,000	0.793832241	$   19,845.81
4	$25,000	0.735029853	$   18,375.75
5	$25,000	0.680583197	$   17,014.58
			$   99,817.75
		Less: Initial investment	$ 100000
			$        -182.25

Ranks:

Performance measure	NPV Rank	Payback period rank
Alternative a	1	2
Alternative b	2	1
Alternative c	3	2