Use this information to answer the next six questions. If a particular decision

Question

Use this information to answer the next six questions. If a particular decision method should not be used, indicate why.

Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 8 percent, and that the maximum allowable payback and discounted payback statistics for the project are 3.5 and 4.5 years, respectively.

Time:     0   1   2   3   4   5   6

Cash flow: -$5,000 $1,200 $2,400 $1,600 $1,600 $1,400 $1,200

Use the payback decision rule to evaluate this project; should it be accepted or rejected?

Use the IRR decision rule to evaluate this project; should it be accepted or rejected?

Use the NPV decision rule to evaluate this project; should it be accepted or rejected?

Explanation / Answer

Calculation of present value @ 8% Time Cash Flow   (in$) PVF @ 8% Present Value 0 -5000 1 -5000 1 1200 0.926 1111.2 2 2400 0.857 2056.8 3 1600 0.794 1270.4 4 1600 0.735 1176 5 1400 0.681 953.4 6 1200 0.630 756 2323.8 1. Payback Period method Decision Rule: No. of completed years+ Incremented cash flow Cash flow in the year As in the 4th year we will be having the total cash inflow of $5614.4 which will complete our outflow, so out payaback period is somewehere between 3rd to 4th year Total cash flow till the end of fourth year $5,614.40 Less Initial outflow $5,000 Incremented Cash flow $614.40 Payback Period 3+(614.4/1176) 3.52 years As the period allowable for discounted cash flows is 4.5 years so   project should be accepted as the payback time for this project is 3.52 years 2 Decision based on IRR: Time Cash Flow(in$) PVF @ 8% P.V @ 8% PVF @ 18% P.V @ 18% 0 -5000 1 -5000 1 -5000 1 1200 0.926 1111.2 0.847 1016.4 2 2400 0.857 2056.8 0.718 1723.2 3 1600 0.794 1270.4 0.609 974.4 4 1600 0.735 1176 0.516 825.6 5 1400 0.681 953.4 0.437 611.8 6 1200 0.630 756 0.37 444 NPV 2323.8 595.4 IRR Lower Rate+ (NPV of Lower rate * Difference in rates (Difference of NPV) IRR     = 21.44% As IRR is 21.44% is higher then the required rate of return of project which is 8%, so project should be accepted 3 Calculation of NPV Time Cash Flow   (in$) PVF @ 8% Present Value 0 -5000 1 -5000 1 1200 0.926 1111.2 2 2400 0.857 2056.8 3 1600 0.794 1270.4 4 1600 0.735 1176 5 1400 0.681 953.4 6 1200 0.630 756 2323.8 As the NPV of the project is positive i.e $2323.8, hence project should be accepted

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