Question

In: Finance

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

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:

  • Calculate the payback period for each project.
  • Which project(s) would you accept based on the payback criterion?
  • Calculate the internal rate of return (IRR) for each project.
  • Which projects would you accept based on the IRR criterion?
  • Calculate the net present value (NPV) for each project.
  • Which projects would you accept based on the NPV criterion
  • 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

Solutions

Expert Solution

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.


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