Global Auto wants to choose the better of two mutually exclusive projects for ex
ID: 1176150 • Letter: G
Question
Global Auto wants to choose the better of two mutually exclusive projects for expanding the firm’s production capacity. The relevant cash flows for the projects are shown in the following table. The firm’s cost of capital is 15%.
Initial Cash Outslow (CF0):
Project A
Project B
$650,000
$358,000
Year (t)
Cash Inflows (CFt)
1
$100,000
$154,000
2
122,000
122,000
3
175,000
150,000
4
289,000
100,000
5
275,000
55,000
a. Calculate the IRR for each of the projects. Which project is preferred, based on the IRR?
b. Calculate the payback for each of the projects. Which project is preferred, based on the payback?
**All work must be shown for full credit.
Initial Cash Outslow (CF0):
Project A
Project B
$650,000
$358,000
Year (t)
Cash Inflows (CFt)
1
$100,000
$154,000
2
122,000
122,000
3
175,000
150,000
4
289,000
100,000
5
275,000
55,000
Explanation / Answer
a. Project A Project B IRR 12.40% 23.31% Working: On the basis of IRR, Project B is acceptable. IRR is the rate at which Net Present Value is zero. Net Present Value at 10% Net Present Value at 10% Project A Project B Year Cash Flows Discount factor Present Value Cash Flows Discount factor Present Value 0 $ -6,50,000 1.0000 $ -6,50,000 $ -3,58,000 1.0000 $ -3,58,000 1 $ 1,00,000 0.9091 $ 90,909 $ 1,54,000 0.9091 $ 1,40,000 2 $ 1,22,000 0.8264 $ 1,00,826 $ 1,22,000 0.8264 $ 1,00,826 3 $ 1,75,000 0.7513 $ 1,31,480 $ 1,50,000 0.7513 $ 1,12,697 4 $ 2,89,000 0.6830 $ 1,97,391 $ 1,00,000 0.6830 $ 68,301 5 $ 2,75,000 0.6209 $ 1,70,753 $ 55,000 0.6209 $ 34,151 NPV $ 41,360 NPV $ 97,976 Net Present Value at 20% Net Present Value at 30% Project A Project B Year Cash Flows Discount factor Present Value Cash Flows Discount factor Present Value 0 $ -6,50,000 1.0000 $ -6,50,000 $ -3,58,000 1.0000 $ -3,58,000 1 $ 1,00,000 0.8333 $ 83,333 $ 1,54,000 0.7692 $ 1,18,462 2 $ 1,22,000 0.6944 $ 84,722 $ 1,22,000 0.5917 $ 72,189 3 $ 1,75,000 0.5787 $ 1,01,273 $ 1,50,000 0.4552 $ 68,275 4 $ 2,89,000 0.4823 $ 1,39,371 $ 1,00,000 0.3501 $ 35,013 5 $ 2,75,000 0.4019 $ 1,10,516 $ 55,000 0.2693 $ 14,813 NPV $ -1,30,784 NPV $ -49,248 Project A Project B NPV at 10% $ 41,360 $ 97,976 NPV at 20% $ -1,30,784 NPV at 30% $ -49,248 IRR = 10%+(20%-10%)*(41360/(41360+130784)) = 12.40% IRR = 10%+(30%-10%)*(97976/(97976+49248)) = 23.31% b. Project A Project B Payback period 3.88 Years 2.55 Years On the basis of Payback period, Project B is acceptable. Working: Project A Project B Year Cash Flows Cumulative cash flows Cash Flows Cumulative cash flows 0 $ -6,50,000 $ -6,50,000 $ -3,58,000 $ -3,58,000 1 $ 1,00,000 $ -5,50,000 $ 1,54,000 $ -2,04,000 2 $ 1,22,000 $ -4,28,000 $ 1,22,000 $ -82,000 3 $ 1,75,000 $ -2,53,000 $ 1,50,000 $ 68,000 4 $ 2,89,000 $ 36,000 $ 1,00,000 $ 1,68,000 5 $ 2,75,000 $ 3,11,000 $ 55,000 $ 2,23,000 Payback Period of Project A = 3+(253000/289000) = 3.88 Years Payback Period of Project B = 2+(82000/150000) = 2.55 Years
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