You are considering two projects: Project 1 and Project 2. Both projects will re

Question

You are considering two projects: Project 1 and Project 2. Both projects will return an annuity after an initial investment in the project. You know from your finance course that the present value of an annuity (that is, a payment made every year in perpetuity) is equal to

PV= A r where A = annual return per year and r = discount rate.

You only have time and personnel to select one project; that is, these two projects are mutually exclusive. Assume that the discount rate (r) is 13 percent. The first project (Project 1) has an initial investment of $100,000 but returns an amount (A) of $24,000 per year forever starting at the end of the first year. The second project (Project 2) has an initial investment of $1000 but returns $4000 per year (forever) beginning at the end of the first year.

For both projects, calculate the Payback period, NPV, IRR, and PI (profitability index). Based on these metrics, which project would be more attractive if you could only select one project? Support your answer.

Explanation / Answer

Project 1 Project 2 Discount rate 13% 13% Initial Investment 100,000 1,000.00 Returns 24,000 4,000 Life   Infinity Infinity Present value of annual cash inflow = C/r C/r C = Annual Cash Inflow = 24000/.13 4000/.13 r = Discount rate = 184,615 30,769 Less: Initial Outlay =          100,000 1,000 Net Present Value (NPV) = 84,615 29,769 Payback Period (Years) = Initial Investment/Annual Cash inflow = 100000/24000 1000/4000 = 4.17 0.25 Profitability Index = Present value of cash inflow/Initial Investment = 184615/100000 30769/1000 = 1.85 30.77 In my opinion, Project 2 is better because of higher profitabilty index of 30.77 in comparison of 1.85 of Project 1 However, to meet the object of wealth maximazation, NPV based Project 1 may be better.

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