1. A firm is considering two mutually exclusive investments, each with an initia
ID: 2387119 • Letter: 1
Question
1. A firm is considering two mutually exclusive investments, each with an initial outlay of $10,000 and an expected life of 3 years. Assume that the firm has a cost of capital of
12 percent for each project. The two investments are of equal risk and have the following cash flows:
Investment A Investment B
Cash Flow Cash Flow
Year 0 -$10,000 -$10,000
Year 1 $4,000 $6,000
Year 2 $5,000 $6,000
Year 3 $11,000 $6,000
Calculate the payback period and the net present value for each investment. Show your calculations.
2. Based on the NPV and payback period calculations, which investment should the firm choose? Why? (20 points)
3. When calculating a firm's cost of capital, why is there a cost associated with retained earnings? (6 points)
Explanation / Answer
Payback period is a straight calculation of when you get your money back. In this case, how long does it take to get $100,000 back.
Payback period for A is approx 2 years, 1 month or 2.090909 years. This is calculated as follows - cash flow through first two years = $90,000, leaving $10,000 balance. 10,000/110,000 = .090909 = approx 1 month past 2 years.
Payback period for B is approx 1 year, 10 months. This is calculated as follows - cash flow through 1 year is $55,000 leaving $45,000 balance. 45,000/55,000 = .818182 = approx 10 months past 1 year.
Present value of cash flows on A is $160,330.58 using payment received at the end of the year . This is a summation of the present values of each cash flow.
Present value of cash flows on B is $136,776.86 using payment received at the end of the year . This is a summation of the present values of each cash flow.
Based on this information, they should choose A because the NPV is 17% greater than B. This problem illustrates why "payback period" alone is not a sufficient method of measurement when evaluating alternative investments.
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