Assume projects are mutually exclusive. Cut off period is 3 years; cost of capit

Question

Assume projects are mutually exclusive. Cut off period is 3 years; cost of capital iis 10%.

Time 0: Project A -600, project B -100, Project C -300

Time 1: Project A 400, project B 500, Project C 250

Time 2: Project A 50, project B 250, Project C 100

Time 3: Project A 300, project B 300, Project C 100

Time 4: Project A 100, project B 400, Project C 800

1. Which project do you select under the payback rule?

2. Which project do you select under the NPV rule?

3. Set up the equation you would use to calculate Project B's IRR

Now assume projects are independent. Cut off period is 3 years; cost of capital is 10%.

4. Which project do you select under the payback rule?

5. Which project do you select under the NPV rule?

Explanation / Answer

1]pay back period for A = 2 + (600-400-50)/300

= 2 + 0.5

= 2.5 YEARS

PAY BACK PERIOD FOR B = 100/500

=0.2 YEARS

PAYBACK PERIOD FOR C = 1+ (300-250)/100

=1.5 YEARS

WE SHOULD ACCEPT PROJECT -B UNDER PAYBACK RULE

2]NPV OF PROJECT -A = 400/(1.10) + 50/(1.10^2) + 300/(1.10^3) + 100/(1.10^4) - 600

= 698.65 - 600

= 98.65

NPV OF PROJECT -B = 500/(1.10) + 250/(1.10^2) + 300/(1.10^3) + 400/(1.10^4) - 100

= 1159.76 - 100

=1059.76

NPV OF PROJECT-C = 250/(1.10) + 100/(1.10^2) + 100/(1.10^3) + 800/(1.10^4) - 300

= 546.41 - 300

= 246.41

BASED ON NPV OF PROJECT-B SHOULD BE SELECTED

3] EQUATION FOR IRR FOR PROJECT B

AT IRR NPV = O

SO EQUATION IS

500/(1+IRR) + 250/(1+IRR) + 300/(1+IRR) + 400/(1+IRR) - 100 = 0

IF CUT OFF PERIOD IS 3 YEARS , COST OF CAPITAL IS 10%

4]WE SHOULD SELECT ALL THE THREE PROJECTS PROJECT UNDER PAYBACK RULE AS THE CUTOFF IS 3 YEARS

5]WE SHOULD ACCEPT ALL THE THREE PROJECTS BECAUSE NPV IS POSITIVE UNDER ALL THE PROJECTS AT A DISCOUNT RATE i.e cutt-off rateOF 10%

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