Question

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ABC Company has 2 mutually exclusive investment options. Information on the two options is reported below:...

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.

Solutions

Expert Solution

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.


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