Comparing Investment Criteria Mario Brothers, a game manufacturer, has a new ide

Question

Comparing Investment Criteria Mario Brothers, a game manufacturer, has a new idea for an adventure game. It can market the game either as a traditional board game or as an interactive DVD, but not both. Consider the following cash flows of the two mutually exclusive projects for Mario Brothers. Assume the discount rate for Mario Brothers is 10 percent. Year Board Game DVD 0 -750 -1,800 1 600 1,300 2 450 850 3 120 350 a. Based on the payback period rule, which project should be chosen? b. Based on the NPV, which project should be chosen? c. Based on the IRR, which project should be chosen? d. Based on the incremental IRR, which project should be chosen?

Explanation / Answer

a) Payback period for board game is -750 + 600 + 300 > 0 => in the second year actually 1.5 years payback period for DVD is -1800 + 1300 + 850 >0 => second year but actually -1800 + 1300 = 500 after 1st year and 500/850 in 2nd year => 0.59 => 1.59 years. Based on payback method we prefer Board Game b) For NPV NPV for Board game = -750 + 600/1.1 + 450/1.1^2 + 120/1.1^3 = 257.51 NPV for DVD = -1800 + 1300/1.1 + 850/1.1^2 + 350/1.1^3= 347.26 Hence we prefer DVD c) Based on IRR Irr for board game be a and say x = 1 + a 750 = 600/x + 450/x^2 + 120/x^3 => x = 1.33786 => IRR = 33.79% similarly let Irr for DVD be b and y = 1 + b 1800 = 1300/y + 850/y^2 + 350/y^3 => y = 1.23307 => 23.31% Based on IRR we prefer Board Game d) Incremental IRR Incremental IRR is Incremental IRR = 15.863 % and hence we prefer DVD Difference in investment is 1800 - 750 = 1150 Assuming we get 33.79% on 750, the rest 1150 yield 15.86% > 10% Hence we prefer DVD

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