Caledonia is considering two additional mutually exclusive projects. The cash fl

Question

Caledonia is considering two additional mutually exclusive projects. The cash flows associated
with these projects are as follows:
YEAR PROJECT A PROJECT B
0 -$100,000 -$100,000
1 32,000 0
2 32,000 0
3 32,000 0
4 32,000 0
5 32,000 $200,000

The required rate of return on these projects is 11 percent.
a. What is each project’s payback period?
b. What is each project’s net present value?
c. What is each project’s internal rate of return?
d. What has caused the ranking conflict?
e. Which project should be accepted? Why?

Explanation / Answer

(a) Payback period is the time in which the whole project cost is recovered. Project A = 100000/32000 = 3.125 year Project B = 4.5 years In case of project B for first 4 years there is no cash flow and hence no recovery but in fifth year there is a cash inflow of 200000. It is assumed that this 200000 occurs proportionately for the whole year and hence 100000 is recovered by year end. 100000/200000 = .5 years. Thus the payback period for this project becomes 4 years + .5 year = 4.5 years. ----------------------------------------------------------------------------------- (b) NPV 5 Project A = -100000 + ? 32000 (1.15) pwr t = $18268 T=0 Project B = -100000 + 200000(1.15) pwr 5 = -$564 ----------------------------------------------------------------------------------- (c) IRR 5 Project A 0 = -100000 + ? 32000 (1+r) pwr t T=0 R = 18.03% Project B 0 = -100000 + 200000(1+r) pwr 5 R = 14.87% ----------------------------------------------------------------------------------- (d) Although the initial cost of project A and B is same and the total cash flow for project A (32000*5 = 160000) is less than the cash flow for project B (200000) ranking conflict is caused because Project A generates the cash flow consistently throughout the project life whereas Project B generates it only at the end of project life and hence project A has the higher ranking. Since the project A has cash flow very early in project life the discount rate applied to its cash inflow are less than that applied to project B which has all the cash flow concentrated in last year. For e.g. the initial cash flow of Project A had present value of just 32000/(1.15) whereas the initial cash flow of B had present value of 200000/(1.15)5. In short discounting creates all the difference. ----------------------------------------------------------------------------------- (e) Project A should be accepted because it has positive NPV and higher IRR.

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