Question

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.

Answer 1

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.