1- Consider the following two mutually exclusive projects: Year Cash Flow (A) Ca

Question

1- Consider the following two mutually exclusive projects: Year Cash Flow (A) Cash Flow (B) 0 -$350,000 -$35,000 1 25,000 17,000 2 70,000 11,000 3 70,000 17,000 4 430,000 11,000 You require a 15 percent return on your investment. Which project you will choose, if any 1. Which investment will you choose if you use the NPV criterion? Why? 2. Which investment will you choose if you use the IRR criterion? Why? 3. Which investment will you choose if you use the profitability index criterion? 4. Which investment will you choose if you use the simple payback criterion? Why? 5. Which investment will you choose if you use the discounted payback criterion? Why? 6. Based on your answers in (1) through (5), which project will you finally choose? Why?

Explanation / Answer

All Amounts in $ Year Project A Project B 0 -350000 -35000 1 25000 17000 2 70000 11000 3 70000 17000 4 430000 11000 Rate of Return on Investment 15% 1. Based on the information given, the Net Present Value (NPV) of both the projects will be Project A $14,390.63 Project B $4,841.09 2. Since the Rate of Return on Investment is 15%, the IRR is calculated using the Trial-and-Error method Project A 16.57% Project B 23.05% 3. Profitability Index = 1 + Net Present Value / Total Investment Required Thus, based on this formula, the Profitability Index for Project A is 1.04 Project B is 1.14 4. The Simple payback period for Project A is 3 years 5.44 months Project B is 2 years 4.94 months 5. For calculating the discounted payback for the two projects, we first need to calculate the discounted cash inflows Discounted Cash Inflows Project A Project B Yearwise 1 21739.13 14782.61 2 52930.06 8317.58 3 46026.14 11177.78 4 245853.9 6289.286 From this chart, the payback period for Project A works out to 3 years 11.19 months Project B works out to 3 years 1.38 months 6. Based on the answers from 1 to 5, Project B needs to be chosen since although it has got a higher IRR, the payback period for both the methods is lower than that of Project A.

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