Question

Consider the following two mutually exclusive projects: Year Cash Flow (A) Cash Flow (B) 0 -$350,000 -$50,000 1 45,000 24,000 2 65,000 22,000 3 65,000 19,500 4 440,000 14,600 Whichever project you choose, if any, you require a 15 percent return on your investment. 1. If you apply the NPV criterion, which investment will you choose? Why? 2. If you apply the IRR criterion, which investment will you choose? Why? 3. If you apply the payback criterion, which investment will you choose? Why? 4. If you apply the discounted payback criterion, which investment will you choose? Why?

Answer 1

Based on the given data, pls find below calculations:

1. If you apply the NPV criterion, which investment will you choose? Why?

Answer: Purely, based on NPV approach, the Project A (with higher NPV) is feasible to choose rather than Project B. The NPV of Project A is almost 4 times higher than Project B.

2. If you apply the IRR criterion, which investment will you choose? Why?

Answer: Purely, based on IRR approach, the Project B (with higher IRR) is feasible to choose rather than Project A. The IRR of Project B is able to generate 24% return on the Investment made.

3. If you apply the payback criterion, which investment will you choose? Why?

Answer: Purely, based on Payback approach, the Project B (with lower Pack back) is feasible to choose rather than Project A. The payback of Project B is 2.2 months.

4. If you apply the discounted payback criterion, which investment will you choose? Why?

Answer: Purely, based on Discounted Payback approach, the Project B (with lower Pack back) is feasible to choose rather than Project A. The payback of Project B is 2.9 months.

Computation:

Computation of IRR: This can be computed using formula in Excel = IRR("range of cashflows", discounting factor%);

Computation of Net Present Value (NPV) based on the Discounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) ; Year 2 = Year 1 factor/(1+discounting factor %) and so on;

Next, the cashflows need to be multiplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;

Computation of Pay Back Period/ Discounted Payback: Here, the period is computed for each project, based on cumulative discounted cash flows: If the cumulative value is less than or equal to zero, the period is considered as 12 months (it means that the net cumulative cash flow has not yet paid back the initial investment); Once the value turns positive in a particular year, the period for such year is observed at a proportion of actual discounted cash flow to the cumulative CF; This gives the period less than 12 months in such year; Once this is computed, total of all the years is taken and divided by 12, to arrive at the Payback period in no.of years.