Question

Solve for problem below and show your work.

A company has the following mutually exclusive projects.

Year     Project A          Project B

0         -$15,300           -$10,700

1              8,700                5,300

2              7,400                4,300

3              3,100                4,800

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a. Suppose the company's payback cutoff is two years. Which of these two projects should be chosen?

b. Suppose the company uses the NPV rule to rank these two projects. Which projects should be chosen if the appropriate discount rate is 15 percent?

Answer 1

Solution:

Year     Project A          Project B

0         -$15,300           -$10,700

1              8,700                5,300

2              7,400                4,300

3              3,100                4,800

Part A )

Since the payback cutoff is 2 years, we will select the project that will recover the investment in less than 2 years

Project A :

Investment in year 0 = -$15,300

Return in Year 1 and year 2 = 8,700+ 7,400 =$16,100

Project B :

Investment in year 0 = -$10,700

Return in Year 1 and year 2 = 5,300+ 4,300 =$9,600

So we will select project A as it has recovered more than the investment ( $16,100 against 15,300), while project B has not recovered the investment in 2 years (9,600 against 10,700)

Part B :

NPV in case of project A is -101.02 and in case of B is 316.19.

So we will select project B