Question

Time	Cash Flow
0	(362,000)
1	103,000
2	108,000
3	116,000
4	133,000
5	142,000

What are the investment’s payback period, IRR, and NPV, assuming the firm’s WACC is 12%?- show working how you get these calculation.

If the firm requires a payback period of less than 3 years, should this project be accepted? Be sure to justify your choice.

Based on the IRR and NPV rules, should this project be accepted? Be sure to justify your choice.

Which of the decision rules (payback, NPV, or IRR) do you think is the best rule for a firm to use when evaluating projects? Be sure to justify your choice.

Answer 1

Please follow the excel file attached for the detailed calculation done for NPV, IRR and payback period calculation.

NPV is calculated using following formula in Excel: NPV(WACC, CASHFLOW YEAR1: YEAR5) +CASHFLOW YEAR0

NPV comes as $63726.25 which is positive.

IRR is calculated using following formula in Excel: IRR(CASHFLOW YEAR0: YEAR5)

IRR comes as 18.47% which is greater than WACC of 12%

For payback period calculation, we have added one extra column in Excel as "Balance".

Balance of Time period 1 calculated by: cashflow year0+cashflow year1 =-362000+103000= -259000

going by same calculation logic, year2, 3 & 4 balance comes as -151000,-35000,98000.

As in year4 balance becomes positive, we can understand payback is happening between year 3 and 4.

So, payback period= 3 Years +(-(-35000/133000) =3.26 Years

Now, if the firm requires a payback period of less than 3 years, this project is not accepted as payback period comes as 3.26 Years.

Based on both NPV and IRR, this project should be accepted as NPV is positive, $63726.25

IRR comes as 18.47% which is greater than WACC of 12%?.So, project is in acceptance criteria based on IRR too.

Among, NPV, IRR and payback, payback is least important in terms of final decision making. It is used for initial filtering based on how early investors want get back their money. Payback doesn't consider cashflow once balance becomes positive or investor's money is back.Then among NPV and IRR, if both indicating for accepting the project like this case then both are fine. But if NPV, IRR produce difference acceptance criteria, thumb rule is going for NPV. Because higher IRR but lower NPV project 'might not be preferred'in cases where IRR might be lower in another project but that project duration is higher and project NPV is also much higher.

Basically NPV is always considered as the most important acceptance criteria as IRR doesn't consider project duration and project size. So going by IRR, one small project might become more significant compared to multi year large project with better NPV.

So, while in conflict, always go for NPV.

	A	B	C
1	WACC	0.12
2
3	Time	Cash Flow	Balance
4	0	-362000	-362000
5	1	103000	-259000
6	2	108000	-151000
7	3	116000	-35000
8	4	133000	98000
9	5	142000
10
11	NPV=NPV(B1,B5:B9)+B4	$63,726.25
12
13	IRR=IRR(B4:B9)	18.47%
14
15	Payback Period=3 + (- C7)/B8 Years	3.26 Years