Question

Smith Technologies has a WACC of 14%, and is currently evaluating two projects for this year’s capital budget. Project A has a cost of $6000 and its expected cash inflows are $2000 for 5 years. Project B has a cost of $18000 and its expected cash inflows are $5600 for 5 years.

a. Calculate NPV, IRR, payback for each project.

b. Assuming the projects are independent which one(s) would you recommend for each method? Why?

c. If the projects are mutually exclusive, which would you recommend for each method? Why?

Answer 1

Project A
a)		Present value of cash inflow	=	Cash inflow per year*PVAF(rate,time)
					=	$2,000*PVAF(14%,5)
					=	$2,000*3.4331
					=	$                              6,866.20
		Initial cost		=	$6,000
	1)	NPV			=	present value of cash inflow-Initial cost
		NPV			=	$6866.2-$6,000
					=	$                                  866.20
	3)	Payback period		=	Period when cummulative cashflow equals initialcost
		calculation of cummulative cashflow
			Year	Opening cummulative cashflow	Cashflow	Closing Cummulative cashflow
			1	$             -	$2,000	$2,000
			2	$2,000.00	$2,000	$4,000
			3	$4,000	$2,000	$6,000
		The cummulative cashflow in year 3 is $6,000.Hence payback period is 3 years
4)		IRR	=	19.86%
		IRR can be calculated using financial calculator or excel.There is no direct method to calculate IRR
Project B
a)		Present value of cash inflow	=	Cash inflow per year*PVAF(rate,time)
					=	$5,600*PVAF(14%,5)
					=	$5,600*3.4331
					=	$                            19,225.36
		Initial cost		=	$18,000
	1)	NPV			=	present value of cash inflow-Initial cost
		NPV			=	$19,225.36-$18,000
					=	$                              1,225.36
	3)	Payback period		=	Period when cummulative cashflow equals initialcost
		calculation of cummulative cashflow
			Year	Opening cummulative cashflow	Cashflow	Closing Cummulative cashflow
			1	$             -	$5,600	$5,600
			2	$5,600	$5,600	$11,200
			3	$11,200	$5,600	$16,800
			4	$16,800	$5,600	$22,400
		The cummulative cashflow in year 3 is $16,800 and year 4 is $22,400.There fore payback period lies between year 3 and year 4
		Calculation of payback period
		Amount required for payback in year 4	=	Initial investment-Cummulative cashflow till year 7
						=	$18,000-$16,800
						=	$                    1,200.00
		Part of 4thyear in erning $1200		=	$,1200/total cashflow in yr 8
						=	$1200/$5600
						=	0.21
			Payback period		=	3year+part of yr 4
						=	3+0.21
						=	3.21 years
4)	IRR	=	16.80%
b)	If the project are independent ,we will select both the project as they both have positive NPV.A project with positive NPV adds to the value of firm
c)	If the project are mutully exclusive we shall select the project with Highest NPV.Hence we will choose projcet B because NPV of project B ($1225) is more thanNPV of project A($866)
	NPV is the best criterion for deciding Mutually exclusive project because it directly tells what value does a project will add to the firm.