17 Comparing Investment Criteria LO1 2 3 5 7 Conside mutuall

17. Comparing Investment Criteria LO1, 2, 3, 5, 7 Conside mutually exchusive projects: Year Cash Flow (A)Cash Flow (B) -$455,000 58,000 85,000 85,000 572,000 $85.000 31,000 28.000 25.000 19.000 2 Whichever project you choose, if any, you require a rerun of 11 percent on your mvestment. 1. If you apply the payback criterion, which investment will you choose? Why? 1. If you apply the discounted payback criterion, which investment will you choose? \\Why? 1. If you apply the NPV criterion, which investment will you choose? Why? 1. If you apply the IRR criterion, which investment will you choose? Why? 1. If you apply the profitability index criterion, which investment will you choose 1. Based on your answers in (a) through (e), which project will you finally choose? Why?

Solution

Answer a) Computation of Payback period Project A Total cash flows for 3 years =58,000+85,000+85000= 228,000 Cash flow for 4th year = 572,000 Payback period = 3 years + 455,000-228,000/572,000 x 12 3 years and 4.8 mn Computation of Payback period Project B Total cash flows for 2 years = 31,000+28,000 = 59,000 Cash flow for 3rd year = 25,000 Payback period = 2 years + 65,000- 59,000/25,000 x 12 2 years and 2.9 mn Here Project B is acceptable because of its shorter payback period. Answer b) Discounted payback period PROJECT A PROJECT B Year Present value @ 11% Cash flows (Project A) Present value Cumulative Present value Cash flows (Project B) Present value Cumulative Present value 1 0.901 58,000 52,252 52,252 31,000 27928 27928 2 0.812 85,000 68,988 121,240 28,000 22725 50653 3 0.731 85,000 62,151 183,391 25,000 18280 68933 4 0.659 572,000 376,794 560,186 19,000 12516 81449 Project A Cumulative present value of cash inflows at the end of 3 years is 183,391 and it is 560,186 in the 4th year so discounted payback period falls in between 3 and 4 years.To be exact Discounted Pay-back period = 3 years + 271609 376,794 3 years and .72 mn Project B Cumulative present value of cash inflows at the end of 2 years is 50653 and it is 68933 in the 3RD year so discounted payback period falls in between 2 and 3 years.To be exact Discounted Pay-back period = 2 years + 271609 14,347 18,280 2 years and .78 mn Answer c) PROJECT A PROJECT B Year Present value @ 11% Cash flows (Project A) Present value Cash flows (Project B) Present value 0 1 -455,000 -455,000 -65,000 -65000 1 0.901 58,000 52,252 31,000 27928 2 0.812 85,000 68,988 28,000 22725 3 0.731 85,000 62,151 25,000 18280 4 0.659 572,000 376,794 19,000 12516 Net Present value 105,186 16449 Answer e) Profitability Index (PI) = Present value of cash inflows 560186 81449 Present value of cash outflows 455,000 65,000 1.23 1.25 According to NPV method project A is acceptable because of its positive NPV but according to the Profitability Index (PI) Project B is acceptable because of higher P.I. Answer d) Cash flow table at various assumed Discount rates PROJECT A Year Cash flows (Project A) Present value @ 15% Present value Present value @ 14% Present value 1 58,000 0.667 38,667 0.877 50,877 2 85,000 0.580 49,275 0.769 65,405 3 85,000 0.504 42,848 0.675 57,373 4 572,000 0.438 250,733 0.592 338,670 381,523 512324 The present value of cash flows at 14% rate of discount is 51,2324 and at 15% rate of discount is 381,523. So the intial cost of investment $ 455,000 falls between these two discount rates.At 14% the NPV is positive 57,324 but at 15% it is negative 73,477, we may say that IRR = 14% +    57,324 X (15%-14%) 14.45% 57,324+73,477 Cash flow table at various assumed Discount rates PROJECT B Year Cash flows (Project B) Present value @ 24% Present value Present value @ 22% Present value 1 31,000 0.806 25,000 0.820 25,410 2 28,000 0.656 18,358 0.672 18,812 3 25,000 0.529 13,219 0.551 13,768 4 19,000 0.426 8,102 0.451 8,577 64,679 66566 The present value of cash flows at 22% rate of discount is 66566 and at 24% rate of discount is 66566 . So the intial cost of investment $ 65,000 falls between these two discount rates.At 22% the NPV is positive 1566 but at 24% it is negative 321, we may say that IRR = 22% +    1,566 X (24%-22%) 22.18% 1566+321 So, Project B is acceptable as it has low payback period and discounted payback period than A project and has high P.I. and Positive NPV and also it has greater IRR than Project A.