Question

Harry Davis Inc is considering the following projects:

Year   Project 1   Project 2   Project 3   Project 4
0   $(50,000,000)   $(25,000,000)   $(25,000,000)   $(50,000,000)
1   $15,000,000    $10,000,000    $5,000,000    $22,000,000
2   $15,000,000    $15,000,000    $10,000,000    $17,000,000
3   $15,000,000    $17,000,000    $5,000,000    $13,500,000
4   $15,000,000    $25,000,000    $11,000,000    $10,000,000
5   $15,000,000    $(35,000,000)   $10,000,000    $8,000,000

The company has a weighted average cost of capital of 11.20% (this is the firm’s required return).

1. Calculate the Net Present Value (NPV) of each project.
2. Calculate the Internal Rate of Return (IRR) of each project.
3. Calculate the Payback Period for each project. (Harry Davis requires all new projects have a payback period of 4 years or less)
4. If these four projects are independent, which one(s) should be accepted? Why?
5. If these four projects are mutually exclusive, which one(s) should be accepted? Why?

Answer 1

1.Project 1

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

• Press the CF button.
• CF0= -$50,000,000. 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 weighted average cost of capital of 11.20%.
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 11.20% the weighted average cost of capital is $5,160,665.43.

Project 2

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

• Press the CF button.
• CF0= -$25,000,000. 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 weighted average cost of capital of 11.20%.
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 11.20% the weighted average cost of capital is $4,252,130.76.

Project 3

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

• Press the CF button.
• CF0= -$25,000,000. 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 weighted average cost of capital of 11.20%.
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 11.20% the weighted average cost of capital is $4,295,112.77.

Project 4

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

• Press the CF button.
• CF0= -$50,000,000. 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 weighted average cost of capital of 11.20%.
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 11.20% the weighted average cost of capital is $4,595,201.52.

2.Project 1

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

• Press the CF button.
• CF0= -$50,000,000. 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 project is 15.24%.

Project 2

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

• Press the CF button.
• CF0= -$25,000,000. 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 project is -18.93%.

Project 3

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

• Press the CF button.
• CF0= -$25,000,000. 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 project is 17.21%.

Project 4

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

• Press the CF button.
• CF0= -$25,000,000. 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 project is 15.57%.

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

Project 1

Payback period= 3 years + $5,000,000/ $15,000,000

                              = 3 years + 0.33

                              = 3.33 eyars.

Project 2

Payback period= $10,000,000 + $15,0000,000

                              = $25,000,000

                              = 2 years.

Project 3

Payback period= 3 years + $5,000,000/ $11,000,000

                              = 3 years + 0.45

                              = 3.45 years.

Project 4

Payback period= 2 years + $11,000,000/ $13,500,000

                              = 2 years + 0.81

                              = 2.81 years.

4.If the projects are independent, all 4 projects can be accepted since all have a positive net present value.

5.If the projects are mutually exclusive, project 1 should be accepted since it has the highest net present value.

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