12. Caledonia is considering two additional mutually exclusive projects. The cas

Question

12. Caledonia is considering two additional mutually exclusive projects. The cash flows associated
with these projects are as follows:
YEAR PROJECT A PROJECT B
0 -$100,000 -$100,000
1 32,000 0
2 32,000 0
3 32,000 0
4 32,000 0
5 32,000 $200,000
The required rate of return on these projects is 11 percent.
a. What is each project’s payback period?
b. What is each project’s net present value?
c. What is each project’s internal rate of return?
d. What has caused the ranking conflict?
e. Which project should be accepted? Why?

Explanation / Answer

Proj A : Payback Method :- COnventional Payback period is The payback period, defined as the expected number of years required to recoverthe original investment. Payback Period = Years before full recovery of Investment + Unrecovered cost at start of year/cash flow during year Investment = 100,000 AMount recoverd till end of Y3 =32000+32000+32000 = 96,000. So Years before full recovery of Investment = 3 Yrs Balance remaining 100000-96000 = 4000 So we get Payback period (PBP) = Years before full recovery of Investment + Unrecovered cost at start of year/cash flow during year Y4 ie PBP = 3 + 4000/32000 = 3+ 0.125 = 3.125rs = 3.125*12months = 37.5 months..Ans (A1) b. What is each project’s net present value? Using excel NPV function, we get NPV = NPV(Rate, CFs) ie NPVa = NPV(11%, -100000,32000,32000,32000,32000,32000) = $16,458.29...Ans(A2) c. What is each project’s internal rate of return? Using Excel IRR function, we get IRR = IRR(CFs) ie IRR = IRR(-100000,32000,32000,32000,32000,32000) = 18.03%....Ans (A3) Proj B : Payback Period = Years before full recovery of Investment + Unrecovered cost at start of year/cash flow during year Investment = 100,000 AMount recoverd till end of Y4 =0. So Years before full recovery of Investment = 4 Yrs Balance remaining 100000 So we get Payback period (PBP) = Years before full recovery of Investment + Unrecovered cost at start of year/cash flow during year Y5 ie PBP = 4 + 100,000/200,000 = 4+ 0.5 = 4.5yrs = 4.5*12months = 54 months...Ans (B1) b. What is each project’s net present value? Using excel NPV function, we get NPV = NPV(Rate, CFs) ie NPVa = NPV(11%, -100000,0,0,0,0,200000) = $16,838.08...Ans(B2) c. What is each project’s internal rate of return? Using Excel IRR function, we get IRR = IRR(CFs) ie IRR = IRR(-100000,0,0,0,0,200000) = 14.87% d. COnflict is due to a single CF of 200K in Proj B. This is very risky as any change in economic conditions, mkt demand etc can result in total loss. ALso the cost of capital at 11% may go up during 4 yrs resuting in poor IRR e. As per PBP, NPV & IRR calcultaions, Proj A is more profitable & reliable. It has even cash flows which is much better than Proj B which has a single Lumpsum CF of 200 k after 5 yrs. This is high risk.

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