As the director of capital budgeting for Denver Corporation

As the director of capital budgeting for Denver Corporation, you are evaluating two mutually exclusive projects. Project X is a three year project and project Z is a four year project. The project net cash flows are followed: Project X Project z Year Cash Flow -$200, 000 70,000 120,000 140,000 -$300,000 50,000 80,000 100,000 270,000 Denver\'s cost of capital is 15 percent. .What is project Z\'s payback period? If the cut off period for the company is 3 years, will you accept project X? . What is project X\'s discounted payback period? If the cut off period for the company is 3 years, will you accept project Z? 3. What is each project\'s NPV? Which project would you choose based on NPV rule? 4. What is each project\'s IRR? Which project would you choose based on IRR rule? S. Why IRR rule and NPV rule lead to different decisions? Which rule is more appropriate to evaluate mutually exclusive projects? Why?

Solution

project x pay back period :

pay back is the number of days required by a project to recover its original investment ;

the outflow of cash in project x is : $2,00,000

the pay back period is = 2 + 10,000/1,40,000 = 2.07 years

yes we will accept project X, as the pay back period is less than the cut off period.

for project Z :

the outflow of cash is = $3,00,000

the pay back period is = 3 + 70,000/ 2,70,000 = 3.259 years .

2. the pay back period method does not take into account teh time value of money. the discounting pay back period method takes into account the time value of money .

project x:

year 0 : (2,00,000)

year 1 : 60869 ( 70,000/1.15 )

year 2 : 90737 (1,20,000/1.15^2)

year 3 : 92052 (1,40,000/1.15^3)

discounted pay back : 2 + 48394/92052

= 2.525 years

project z:

year 0 = ($3,00,000)

year 1: $43,478.26

year 2 :$60,491.49

year 3 :$65,751.62

year 4 : $154373.37

discounted pay back period = 3 + (154373.37 - 130278.6)/ 154373.37

= 3 + 0.156

=3.156 years

no we will not accept the project. as the pay abck period is more than teh cut off period.

3. NPV of project x :

($200,000) + 70,000/1.15 + 120,000/1.15^2 + 1,40,000/1.15^3

= $43,659

IRR = 26.34

NPV of project z : $24,094.75

IRR = 17.99

ACCORDING TO THE NPV RULE, THE PROJECT WITH THE HIGHER NPV SHOULD BE CHOSEN, THE PROJECT X HAS A HIGHER NPV . SO X SHOULD BE CHOSEN .

4. IRR is the rate at which the NPV is zero.

project x :

($70,000) + 70,000(1+x ) + 1,20000/(1+x )^2 + $1,40,000/(1+x )^3 = 0

the IRR is : 26.34

project z IRR is = 17.99

so, the project with the higher IRR should be chosen. so, project X should be chosen.