A company facing an interest rate of 8% must choose among projects offering the

Question

A company facing an interest rate of 8% must choose among projects offering the following four-year cash flows. If the company is employing the net present value criterion, which project should they choose?

Answer

$15,000 in year 1; $15,000 in year 2; $15,000 in year 3; and $15,000 in year 4

$5,000 in year 1; $5,000 in year 2; $25,000 in year 3; and $25,000 in year 4

$5,000 in year 1; $5,000 in year 2; $20,000 in year 3; and $30,000 in year 4

$25,000 in year 1; $15,000 in year 2; $10,000 in year 3; and $5,000 in year 4

A project manager is using the payback method to make the final decision on which project to undertake. The company has a 10% required rate of return and expects a 4% rate of inflation for the following five years. What is the non-discounted payback of a project that has cash flows as shown in the table?

Answer

5.0 years

2.6 years

3.4 years

4.2 years

A.

$15,000 in year 1; $15,000 in year 2; $15,000 in year 3; and $15,000 in year 4

B.

$5,000 in year 1; $5,000 in year 2; $25,000 in year 3; and $25,000 in year 4

C.

$5,000 in year 1; $5,000 in year 2; $20,000 in year 3; and $30,000 in year 4

D.

$25,000 in year 1; $15,000 in year 2; $10,000 in year 3; and $5,000 in year 4

Explanation / Answer

1)

Net present value of different options:

NPV1 = 15000/(1.08) + 15000/(1.08^2) + 15000/(1.08^3) +15000/(1.08^4) = $49,681.9

NPV2 = 5000/(1.08) + 5000/(1.08^2) + 25000/(1.08^3) +25000/(1.08^4) = $47,137.88

NPV3 = 5000/(1.08) +5000/(1.08^2) +20000/(1.08^3) +30000/(1.08^4) = $46,843.86

NPV4 = 25000/(1.08) +15000/(1.08^2) +10000/(1.08^3) +5000/(1.08^4) = $47,621.7

NPV is maximum for option A = $49,681.9

2)

Non discounted payback period is time when we get back invested 100,000

we get back 70,000 in first 2 years and remaing in 3 years

So, payback period = 2 + ( (100000-70000)/50000) = 2.6 years

2.6 years

B.

2.6 years

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