In: Finance
Senior management asks you to recommend a decision on which project(s) to accept based on the cash flow forecasts provided.The firm uses a 3-year cutoff when using the payback method. The hurdle rate used to evaluate capital budgeting projects is 15%.
Assume the projects are independent and answer the following:
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 |
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:
The IRR of the project is 21.96%.
Project B
Internal rate of return is calculated using a financial calculator by inputting the below:
The IRR of the project is 19.79%.
Project C
Internal rate of return is calculated using a financial calculator by inputting the below:
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:
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:
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:
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.