Question

16. Bagel Pantry Inc. is considering two mutually exclusive projects with widely differing lives. The company's cost of capital is 12%. The project cash flows are summarized as follows:

                        Project A          Project B

    C₀                      ($25,000)         ($23,000)

    C₁                      $14,742          $ 6,641

    C₂                      $14,742          $ 6,641

    C₃                      $14,742          $ 6,641

    C₄                                                      $ 6,641

    C₅                                                      $ 6,641

    C₆                                                      $ 6,641

    C₇                                                      $ 6,641

    C₈                                                      $ 6,641

    C₉                                                      $ 6,641

1. Compare the projects by using Payback.
2. Compare the projects by using NPV.
3. Compare the projects by using IRR.
4. Compare the projects by using the replacement chain approach.
5. Compare the projects by using the EAA method.
6. Chose a project and justify your choice.

Answer 1

1. Payback Method

Payback Period = Initial Investment / Net annual cashflows

For Project A:

Intial Investment = $25,000

Net annual cashflows = $14742

Payback Period (Project A) = 25000/14742 = 1.695 Years

For Project B:

Intial Investment = $23,000

Net annual cashflows = $ 6641

Payback Period (Project B) = 23000/6641   = 3.463 Years

Hence, Project A is better than Project B as money is getting returned in a much shorter time.

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1. NPV Method

For Project A

We can calculate NPV in the following way

Discount Rate (r)	12%
years	0	1	2	3
Cash-Outflows	25,000
Cash-Inflows		14,742	14,742	14,742
Net Cashflows (Inflow - Outflow)	-25,000	14,742	14,742	14,742
Discounted Cashflow = Net CF / (1+r)^years	-25,000	13,163	11,752	10,493
NPV = sum of all discounted CF	10,407.80

IRR = IRR (net CF)

35.002%

For Project B

We can calculate NPV in the following way

Discount Rate (r)	12%
years	0	1	2	3	4	5	6	7	8	9
Cash-Outflows	23,000
Cash-Inflows		6,641	6,641	6,641	6,641	6,641	6,641	6,641	6,641	6,641
Net Cashflows (Inflow - Outflow)	-23,000	6,641	6,641	6,641	6,641	6,641	6,641	6,641	6,641	6,641
Discounted Cashflow = Net CF / (1+r)^years	-23,000	5,929	5,294	4,727	4,220	3,768	3,365	3,004	2,682	2,395
NPV = sum of all discounted CF	12,384.91
IRR = IRR (net CF)	24.998%

Hence we can see that NPV (Project B) > NPV (Project A).

Hence, we should chose Project B over Project A if NPV method is considered

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3. IRR Method

In the above method we have already calculated the IRR

IRR (Project A) = 35.002%

IRR (Project B) =   24.998 %

Hence, IRR (Project A) > IRR (Project B)

Hence, we should chose Project A over Project B if IRR method is considered