Question

Etisalat is in the process of choosing the better of two equal-risk, independed capital expenditure projects-A and B. The relevant cash flows for each project are shown in the following table. The firm's cost of capital is 14%.
   
Project A
Project B
Initial investment
$27000
$25,000
1
$10,000
$11,000
2
$10,000
$10,000
3
$10,000
$9,000
4
$10,000
$8,000
Required:
a. Calculate each project's payback period. what are the disadvantages of the payback period?

b. Calculate the net present value (NPV) for each project.
c. Calculate Profitability Index (PI) for each project.
d. If you are given the internal rate of return (IRR) for project A is 18% and IRR for Project B is 20 %, which one you select and why?
e. Summarize the preferences dictated by each measure (Payback period, NPV, PI, IRR), and indicate which project you would recommend. Explain why?

Answer 1

	Year	Project A	Project B	Discount factor @ 14%	NPV of A	NPV of B
	0	-27000	-25000	1	(27,000)	(25,000)
	1	10000	11000	0.877192982	8,772	9,649
	2	10000	10000	0.769467528	7,695	7,695
	3	10000	9000	0.674971516	6,750	6,075
	4	10000	8000	0.592080277	5,921	4,737
		13000	13000		2,137	3,155
a	Payback period	A	B
		2.84	2.53
	When NPV is zero - All cash investments are earned back
	A	(7k in year 3 earned in 0.84 years as 1 year earns 10k 7000/10000*12 months)
	B	(4k in year 3 earned in 0.53 years as 1 year earns 9k 4000/9000*12 months)
	Discount factor	1/1+r^t
b	NPV is discouned cash flows.	A	B
		2137	3155
c	Profitability index	PV of cash inflow/PV of cash outflows
		A	B
	Cash inflows	29,137	28,155
	Cash outflows	27,000	25,000
		1.08	1.13
d	IRR is the rate where NPV is 0. It is the rate of return earned by the project. The greater the IRR, better is the profiatbility of the project
	So choose Project B has IRR of 20% compared to 18% from A
		A	B	Which project to choose	Reason
e	Payback period	2.84	2.53	B	Cash earned back quicker
	NPV	2137	3155	B	More cash flows at discounted terms
	Profitability index	1.08	1.13	B	Better profitablility
	IRR	18%	20%	B	Better rate of return