5Page Safety Tools TCO E A company has the opportunity to do

5Page Safety Tools- (TCO E) A company has the opportunity to do any of the projects for which the net cash flows per year are shown below. The conpany has a cost of capital of 12% which should the ompany do and why? You must use at least two capital budgeting methods. Show your work Year 350 250 250 100 50 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 7:43 PM 200

Solution

Calculation of Net Present Value of each Project

Project A   

Present Value of Cash Inflows = [Cash Inflows for first 5 yrs*PVAF(12%, 5 yrs)]+[Cash Inflows for 6th yr*PVF(12%, 6 yrs)]+[Cash Inflows for 7th yr*PVF(12%, 7 yrs)]

= ($100*3.60478)+($50*0.50663)+($200*0.45235)

= $360.48+$25.33+$90.47 = $476.28

Net Present Value = PV of Cash Inflows - Initial Investment

= $476.28 - $350 = $126.28

Project B

Present Value of Cash Inflows = [Cash Inflows for Ist year*PVF(12%, 1 yr)]+[Cash Inflows for next 6 yrs*PVAF(12%, 6 yrs)]

= ($50*0.89286)+[$100*(0.79719+0.71178+0.63552+0.56743+0.50663+0.45235)

= $44.64+($100*3.6709) = $44.64+367.09 = $411.73

Net Present Value = PV of Cash Inflows - Initial Investment

= $411.73 - $250 = $161.73

Project C

Present Value of Cash Inflows = Cash Inflows for first 6 yrs*PVAF(12%, 6 yrs)

= $100*4.11141 = $411.14

Net Present Value = PV of Cash Inflows - Initial Investment

= $411.14 - $250 = $161.14

Based on NPV analysis, Project B should be selected because the NPV of project B is higher than both project A and C.

Calculation of Payback Period of each Project

Project A

Payback Period = Initial Investment/Average Annual Cash Inflows

Average Annual Cash Inflows = Total Cash Inflows over project Life/Project Life

= ($100+$100+$100+$100+$100+$50+$200)/7 yrs

= $750/7 = $107.14

Payback Period = $350/$107.14 = 3.27 yrs

Project B

Payback Period = Initial Investment/Average Annual Cash Inflows

Average Annual Cash Inflows = Total Cash Inflows over project Life/Project Life

= ($50+$100+$100+$100+$100+$100+$100)/7 yrs

= $650/7 = $92.86

Payback Period = $250/$92.86 = 2.69 yrs

Project C

Payback Period = Initial Investment/Average Annual Cash Inflows

Average Annual Cash Inflows = Total Cash Inflows over project Life/Project Life

= ($100+$100+$100+$100+$100+$100+$0)/7 yrs

= $600/7 = $85.71

Payback Period = $250/$85.71 = 2.92 yrs

Based on payback period, also Project B should be selected because payback period of project B is less than project A and C.