In: Accounting
ABC Company has 2 mutually exclusive investment options. Information on the two options is reported below:
Option A Option B
Initial Investment $150,000 $350,000
Year 1 return $45,000 $100,000
Year 2 return $55,000 $110,000
Year 3 return $60,000 $125,000
Year 4 return $70,000 $110,000
Year 5 return $55,000 $75,000
Year 6 return $60,000
Year 7 return $45,000
Calculate the IRR, NPV (assume a 5% discount rate for NPV calculation), Profitability Index and Payback period for both investments and then determine which one you would choose and explain why.
Solution:
Computation of IRR | ||||
Period | Project A | Project B | ||
Cash inflows | IRR | Cash inflows | IRR | |
0 | -$150,000.00 | 30.94% | -$350,000.00 | 15.31% |
1 | $45,000.00 | $100,000.00 | ||
2 | $55,000.00 | $110,000.00 | ||
3 | $60,000.00 | $125,000.00 | ||
4 | $70,000.00 | $110,000.00 | ||
5 | $55,000.00 | $75,000.00 | ||
6 | $60,000.00 | |||
7 | $45,000.00 |
Computation of NPV and Profitability index | ||||||
Particulars | Period | PV Factor | Project A | Project B | ||
Amount | Present Value | Amount | Present Value | |||
Cash outflows: | ||||||
Initial investment | 0 | 1 | $150,000 | $150,000 | $350,000 | $350,000 |
Present Value of Cash outflows (A) | $150,000 | $350,000 | ||||
Cash Inflows | ||||||
Year 1 | 1 | 0.95238 | $45,000.00 | $42,857 | $100,000.00 | $95,238 |
Year 2 | 2 | 0.90703 | $55,000.00 | $49,887 | $110,000.00 | $99,773 |
Year 3 | 3 | 0.86384 | $60,000.00 | $51,830 | $125,000.00 | $107,980 |
Year 4 | 4 | 0.82270 | $70,000.00 | $57,589 | $110,000.00 | $90,497 |
Year 5 | 5 | 0.78353 | $55,000.00 | $43,094 | $75,000.00 | $58,764 |
Year 6 | 6 | 0.74622 | $60,000.00 | $44,773 | ||
Year 7 | 7 | 0.71068 | $45,000.00 | $31,981 | ||
Present Value of Cash Inflows (B) | $322,011 | $452,253 | ||||
Net Present Value (NPV) (B-A) | $172,011 | $102,253 | ||||
Profitability index (B/A) | 2.15 | 1.29 |
Computation of Cumulative Cash flows | ||||
Period | Project A | Project B | ||
Cash inflows | Cumulative Cash Inflows | Cash inflows | Cumulative Cash Inflows | |
1 | $45,000.00 | $45,000.00 | $100,000.00 | $100,000.00 |
2 | $55,000.00 | $100,000.00 | $110,000.00 | $210,000.00 |
3 | $60,000.00 | $160,000.00 | $125,000.00 | $335,000.00 |
4 | $70,000.00 | $230,000.00 | $110,000.00 | $445,000.00 |
5 | $55,000.00 | $285,000.00 | $75,000.00 | $520,000.00 |
6 | $60,000.00 | $345,000.00 | ||
7 | $45,000.00 | $390,000.00 |
Payback period Project A = 2 years + ($150,000 - $100,000) / $60,000 = 2.83 years
Payback period - Project B = 3 years + ($350,000 - $335,000) / $110,000 = 3.14 years
On the basis of above analysis i will choose project A as its IRR is higher than IRR of project B. IRR is the best measure for decision making. Further NPV and profitability index of project A is higher than Project B. Therefore Project A is best to choose.