Question

The following cash flows have been given for mutually exclusive Projects Alpha and Beta:

Year	ProjectAlpha	ProjectBeta
0	-175000	-82500
1	40000	30000
2	60000	-10500
3	85000	40000
4	92000	75000
5	92000	92000

(a) Use the payback period month to identify which project is more attractive. The requirement is that projects have a payback period of 3 years or less.

(b) At 10% cost of capital, use NPV approach to identify which project should be accepted and why?

(c) Use IRR approach to identify which project to accept, if the cost of capital is 10%

(d) If the cost of capital is 10%, given the results of the 3 approaches, which method should apply to make a final decision and why?

Answer 1

a. Payback period is the time it takes to retain the cost of investment.

For project Alpha, in 2 years, it receives $100,000 and remaining $75000 in 3rd year

3rd year=75000/85000=0.88 years

It takes a total 2.88 years to retain the cost for Project Alpha

For project Beta, in 3 years, it receives $59500 and remaining $23000 in 4th year

4th year=23000/75000=0.31 years

It takes a total 3.31 years to retain the cost for Project Beta.

Based on the pay back period, project Alpha is more attractive because of low payback period

b.

.

=NPV(rate, Year1 to Year5 cashflows)-Year0 cashflow

=NPV(10%, Year1 to Year5 cashflows)-Year0 cashflow

Project Alpha has higher NPV than Project Beta, so project alpha has to be accepted

c. =IRR(values)

=IRR(Year0 to Year5 cashflows)

Based on IRR, project beta has to be selected because of higher IRR and greater than cost of capital (10%)

d. Projects have to be selected based on NPV if there is any conflict with IRR because NPV tells that how much value be added to shareholders wealth. IRR keeps on changing based on the future changes means we can have multiple IRR's for a single project. Hence, NPV is better method to judge a capital decision.