Suppose a company is considering two investment projects. Both projects require

Question

Suppose a company is considering two investment projects. Both projects require an upfront expenditure of $30 million. The company estimates that the cost of capital is 10% and that the investments will result in the following after-tax cash flows (in millions of dollars). Complete parts (a) through (e) below.

Year Project A Project B
1 $28 $10
2 $20 $15
3 $10 $20
4 $5 $25

a) Find the regular payback period for each project.
b) Find the discounted payback period for each project.
c) Assume that the two projects are independent and the cost of capital is 10%. Which project or projects should the company undertake? Base your results on the NPV.
d) Assume that the two projects are mutually exclusive and the cost of capital is 5%. Which project or projects should the company undertake? Base your results on the MIRR.
e) Explain why quantitative measures may not always be the best way to evaluate a project.

Explanation / Answer

a. Payback period of Project A =1+(30-28)/20 =1.10 years Payback period for Project B =2+(30-10-15)/20 =2.25 years b. Project A Present value of year 1 cash flow =$28/1.1 =$25.45454545 Present value of year 2 cash flow =$20/1.1^2 =16.52892562 discounted payback period for project A = 1+(30-25.45454545)/16.52892562 =1.275 years Project B Present value of year 1 cash flow =$10/1.1 =$9.090909091 Present value of year 2 cash flow =$15/1.1^2 =12.39669421 Present value of year 3 cash flow =$20/1.1^3 =$15.02629602 discounted payback period for project A = 2+(30-$9.090909091-12.39669421)/$15.02629602 =2.5665 years c.NPV of Project A =-30 +$28/1.1 + 20/1.1^2 +10/1.1^3 +5/1.1^4 =$22.91 NPV of Project B=-30 +$10/1.1 + $15/1.1^2+$20/1.1^3 +$25/1.1^4=$23.59 The company should take Project B with higher NPV d..NPV of Project A =-30 +$28/1.05 + 20/1.05^2 +10/1.05^3 +5/1.05^4 =$27.559 NPV of Project B=-30 +$10/1.05 + $15/1.05^2+$20/1.05^3 +$25/1.05^4=$30.97 The company should take Project B with higher NPV e. Because the quantitative measures do not take into accounts of the external risks and other macroeconomic factors

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