Question

Wilson’s Market is considering two mutually exclusive projects that will not be repeated. The required rate of return is 13.9 percent for Project A and 12.5 percent for Project B. Project A has an initial cost of $54,500, and should produce cash inflows of $16,400, $28,900, and $31,700 for Years 1 to 3, respectively. Project B has an initial cost of $69,400, and should produce cash inflows of $0, $48,300, and $42,100, for Years 1 to 3, respectively. Based on IRR, which project, if either, should be accepted and why? Based on the Payback Period, which project should be accepted if the cutoff point is 2.5 years.

Answer 1

IRR of Project A

Using financial calculator to calculate the IRR

Inputs: C0= -54,500

C1= 16,400 frequency= 1

C2= 28,900 frequency = 1

C3= 31,700 frequency = 1

Irr= compute

We get, IRR of the project A as 17.43%

IRR of Project B

Using financial calculator to calculate the IRR

Inputs: C0= -69,400

C1= 0 frequency= 1

C2= 48,300 frequency = 1

C3= 42,100 frequency = 1

Irr= compute

We get, IRR of the project B as 11.38%

As the IRR of Project A is more than project B, we should choose Project A .

Payback period of Project A

Years	Cashflow	Cumulative cashflow
0	(54,500)	(54,500)
1	16,400	(38,100)
2	28,900	(9,200)
3	31,700	22,500

Payback period = year before full recovery + Cumulative cashflow before full recovery/ cash flow of the year after recovery

= 2 + 9,200 / 31,700

= 2 + 0.29

= 2.29 years

Payback period of Project B

Years	Cashflow	Cumulative cashflow
0	(69,400)	(69,400)
1	0	(69,400)
2	48,300	(21,100)
3	42,100	21,000

Payback period = year before full recovery + Cumulative cashflow before full recovery/ cash flow of the year after recovery

= 2 + 21,100 / 42,100

= 2 + 0.50

= 2.50 years

As the payback period of Project A is less than that of Project B and, Project A also satisfies the payback period criteria, Wilson should choose Project A .