I have a question on determining the NPV. 1. Two new wind-farm tower projects ar

Question

I have a question on determining the NPV. 1. Two new wind-farm tower projects are proposed for a small company that installs them in south western Wisconsin. Project A will cost $250,000 to complete and is expected to have an annual net cash flow of $75,000. Project B will cost $150,000 to complete and should generate annual net cash flows of $52,000. As a small company, the owner and senior management team are very concerned about their cash flow. Use the payback period method and determine which project is better from a cash flow standpoint. Can someone show me how I can help my son solve this problem so I can guide him through it?

Explanation / Answer

The payback period (PBP) is the amount of time that is expected before an investment will be returned in the form of income. When comparing two or more investments, owner and senior management team will typically compare the projects to see which one has the shorter PBP. Projects with longer PBP are usually associated with higher risk.

We know that,

Payback period = Cost of the investment / Annual Net Cash Flow

For Project A,

Cost of the investment = $250,000

Expected Annual Net Cash Flow = $75,000

Payback period = $250,000 / $75,000 = 3.33

So, the time is 3.33 years in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment.

For Project B,

Cost of the investment = $150,000

Expected Annual Net Cash Flow = $52,000

Payback period =  $150,000 / $52,000 = 2.88

So, the time is 2.88 years in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment.

As, Payback period of project B is smaller as compared with the Payback period of project A, project B is better than project A from a cash flow standpoint

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