Question

Allergia Inc. has the following two mutually exclusive projects:

                      Year                  Cash Flow (A)                        Cash Flow (B)

0                      -$300,000                                -$35,000

1                      25,000                                     16,000

2                      60,000                                     12,000

3                      80,000                                     15,000

4                      120,000                                   13,000

Whichever project you choose, if any, you require a 15 percent return on your investment.

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

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

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

4. If you apply the profitability index criterion, which investment will you choose? Why?

                                                                                                                                     

5. f. Based on your answers in (a) through (e), which project will you finally choose? Why?

                                                                                                                                 

Answer 1

Answer

Method	Project A	Project B	decision rule	Project Selected
Payback	Not Defined	2.46	Project with less payback should be accepted	Project B
NPV	-111680	5282	Project with positive NPV should be accepted	Project B
IRR	-2%	22%	Project with IRR greater than required rate of return should be accepted	Project B
PI	0.63	1.15	Project with PI greater than 1 should be accepted	Project B

Workings

Question A - Payback Period

Payback Period is the time in which initial investment form the project can be recovered, to calculate payback period we will calculate the cumulative cash flows from the project

Project A

Year	Cash Flow	Cumulative Cash Flow
1	25000	25000
2	60000	85000
3	80000	165000
4	120000	285000

Since total cash flow of the project is less than initial investment of 300000 in Year 0, project A's payback cannot be determined (ie it will not recover even the initail investment)

Project B

Year	Cash Flow	Cumulative Cash Flow
1	16000	16000
2	12000	28000
3	15000	43000
4	13000	56000

Payback Period = 2 Year + (initial Investment - Cumulative Cash Flow till year 2) / Cash Flow in Year 3

Payback Period = 2 + (35000-18000)/15000

Payback Period = 2 + 0.466= 2.46 Years

Decision - Since payback of Project B is less we will choose project B

Question B - NPV Method

Project A

Year	Cash Flow	Present Value @15%
0	-300000	-300,000.00
1	25000	21,739.13
2	60000	45,368.62
3	80000	52,601.30
4	120000	68,610.39
	NPV	-111,680.56

Project B

Year	Cash Flow	Present Value @15%
0	-35000	-35,000.00
1	16000	13,913.04
2	12000	9,073.72
3	15000	9,862.74
4	13000	7,432.79
	NPV	5,282.30

Decision - Since NPV of Project B is positive we will choose project B

Question C - IRR Mehod

Year	Cash Flow	Cash Flow
0	-300000	-35000
1	25000	16000
2	60000	12000
3	80000	15000
4	120000	13000
	-2%	22%

Since IRR of Project B is more than required rate of return of 15% we will accept project B

Question D = PI method

PI = Present Value of Inflows / Present Value of Outflows

		Project A	Project B
Year	Cash Flow	Present Value @15%	Present Value @15%
1	25000	21,739.13	13,913.04
2	60000	45,368.62	9,073.72
3	80000	52,601.30	9,862.74
4	120000	68,610.39	7,432.79
	Present Value of Inflows	188,319.44	40,282.30

PI of Project A = 188139 / 300000 = 0.63

PI of Project B = 40282.35 / 35000 = 1.15

If PI is greater than 1 we should accept the project, therefore we will accept project B

Question E

Method	Project A	Project B	decision rule	Project Selected
Payback	Not Defined	2.46	Project with less payback should be accepted	Project B
NPV	-111680	5282	Project with positive NPV should be accepted	Project B
IRR	-2%	22%	Project with IRR greater than required rate of return should be accepted	Project B
PI	0.63	1.15	Project with PI greater than 1 should be accepted	Project B

Project B should be selected