Question

_______ 1. We have two projects A and B that each have a cost of $10,000. Project A has cash flows of $3,250, $3,250, $3,510, $3,510. Project B has cash flows of $800, $770, $4,600, and $9,000. The payback is: PROJECT A PAYBACK = 2.797 YEARs; PROJECT B PAYBACK = 3.654 YEARs. T OR F

______ 2. Using the information from #1, the NPV is $850.52 for A and -1,363.33 for project B. T OR F

______ 3. Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. T OR F

    

______ 4. The key assumption behind NPV and IRR is that future cash flows are re-invested at the required rate of return for NPV and at the internal rate of return for the IRR. T OR F

______ 5. The key assumption behind the MIRR model is that cash flows are re-invested at the required rate of return. T OR F. EXPLAIN YOUR ANSWER IN A SENTENCE OR TWO.

Answer 1

(1.) False

Computation of Payback Period:
	Project A			Project B
Year	Cashflows	Cummulative Cashflow		Cashflows	Cummulative Cashflow
0	$   (10,000)			$       (10,000)
1	$        3,250	$           3,250		$                800	$           800
2	$        3,250	$           6,500		$                770	$       1,570
3	$        3,510	$         10,010		$            4,600	$       6,170
4	$        3,510			$            9,000	$     15,170

Pay Back Period for Project A

Pay back period is the time taken to recover the initial investment.

Pay Back Period = 2 years + [($10,000 - $ 6,500)/($10,010 - $ 6,500)]

Pay Back Period = 2 years + 0.9972

Pay Back Period = 2.9972 years

Pay Back Period for Project B

Pay back period is the time taken to recover the initial investment.

Pay Back Period = 3 years + [($10,000 - $ 6,170)/($15,170 - $ 6,170)]

Pay Back Period = 3 years + 0.4256

Pay Back Period = 3.4256 years

(2)Answer: False

Computation of NPV :

	Computation of NPV
	Year	Cashflows	PVF@ 10 %	PV		Cashflows	PVF@ 10 %	PV
A	0	$                  (10,000)	1.0000	$               (10,000)		$   (10,000)	1.0000	$           (10,000)
		PV of Cash Outflows		$               (10,000)				$           (10,000)
B	1	$                      3,250	0.9091	$                   2,955		$           800	0.9091	$                   727
	2	$                      3,250	0.8264	$                   2,686		$           770	0.8264	$                   636
	3	$                      3,510	0.7513	$                   2,637		$       4,600	0.7513	$                3,456
	4	$                      3,510	0.6830	$                   2,397		$       9,000	0.6830	$                6,147
		PV of Cash Inflows		$                 10,675				$             10,967
	NPV	= B-A		$                       675				$                   967

From the above we can observe, on an assumtion of 10% Cost of Capital, NPV is higher for Project B than Project; the result remains same irrespective of cost of Capital. As per the question NPV of Project A is higher than Project B, HEnce the given statement is False.

(3) True.

Net present value is nothing but net off of the present value of cash inflows and outflows by discounting the flows at a specified rate.

NPV is calculated by taking the difference between the present value of cash inflows and present value of cash outflows over a period of time.

(4) True

While Computing NPV of Project, Cash flows arising in every year are discounted using Cost of Capital, considers implied assumption that those cashflows can be reinvested at Cost of Capital for balance life of the project.

While Computing IRR of Project, Cash flows arising in every year are discounted using expected IRR, which considers implied assumption that those cashflows can be reinvested at same IRR for balance life of the project.

(5) True

The key assumption behind the MIRR model is that cash flows are re-invested at the required rate of return.

That is why, while Computing MIRR of Project, Cash flows arising in every year are taken assumed to be reinvested agt cost of capital and that amount is discounted for computing MIRR.