Question

Task:

Senior management asks you to recommend a decision on which project(s) to accept based on the cash flow forecasts provided.

Relevant information:

1. The firm uses a 3-year cutoff when using the payback method.
2. The hurdle rate used to evaluate capital budgeting projects is 15%.

The cash flows for projects A, B and C are provided below.

	Project A	Project B	Project C
Year 0	-30,000	-20,000	-50,000
Year 1	0	4,000	20,000
Year 2	7,000	5,000	20,000
Year 3	20,000	6,000	20,000
Year 4	20,000	7,000	5,000
Year 5	10,000	8,000	5,000
Year 6	5,000	9,000	5,000

1. Assume the projects are mutually exclusive and answer the following:
   • Which project(s) would you accept based on the payback criterion?
   • Which projects would you accept based on the IRR criterion?
   • Which projects would you accept based on the NPV criterion?

Answer 1

a.Payback period=full years until recovery + unrecovered cost at the start of the year/cash flow during the year

Project A

Payback period= 3 years + $3,000/ $20,000

                              = 3 years + 0.15

                              = 3.15 years.

Project B

Payback period= 3 years + $5,000/ $7,000

                              = 3 years + 0.71

                              = 3.71 years.

Project C

Payback period= 2 years + $10,000/ $20,000

                              = 2 years + 0.50

                              = 2.50 years.

I would recommend project C using the payback criterion since only its payback is lesser than the 3-year cutoff.

b.Project A

Internal rate of return is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$30,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR and CPT button to get the IRR of the project.

The IRR of the project is 21.96%.

Project B

Internal rate of return is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$20,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR and CPT button to get the IRR of the project.

The IRR of the project is 19.79%.

Project C

Internal rate of return is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$50,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR and CPT button to get the IRR of the project.

The IRR of the project is 18.11%.

I would recommend Project A using the IRR criterion since it has the highest IRR.

c.Project A

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$30,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter the hurdle rate of 15%.
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 15% hurdle rate is $7,011.80.

Project B

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$20,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter the hurdle rate of 15%.
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 15% hurdle rate is $3,074.71.

Project C

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$50,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter the hurdle rate of 15%.
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 15% hurdle rate is $3,170.79.

I would recommend Project C according to the NPV criterion since it has the highest net present value.

In case of any query, kindly comment on the solution.