3CH6 Comparing Investment Criteria [LO1, 2, 3, 5, 7] Consider the following two
ID: 2744521 • Letter: 3
Question
3CH6
Comparing Investment Criteria [LO1, 2, 3, 5, 7] Consider the following two mutually exclusive projects:
Year
Cash Flow (A)
Cash Flow (B)
0
$455,000
$65,000
1
58,000
31,000
2
85,000
28,000
3
85,000
25,000
4
572,000
19,000
Whichever project you choose, if any, you require a return of 11 percent on your investment.
Part 1. If you apply the payback criterion, which investment will you choose? Why?
Part 2. If you apply the discounted payback criterion, which investment will you choose? Why?
Part 3. If you apply the NPV criterion, which investment will you choose? Why?
Year
Cash Flow (A)
Cash Flow (B)
0
$455,000
$65,000
1
58,000
31,000
2
85,000
28,000
3
85,000
25,000
4
572,000
19,000
Explanation / Answer
Part1: Payback Period:
Payback period Project A = 3 years + [(455000-228000) / (800000-228000)]
= 3.40 years
Payback Period Project B = 2 years + [(65000-59000) / (84000-59000)]
= 2.24 years
Applying the payback criterion, Project B will be chosen because the payback period is short.
Part 2: Discounted Payback Period:
Discounted Cash flows Project A = 3 years + [(455000-183413) / (560361-183413)]
= 3.72 years
Discounted Cash flows Project B = 2 years + [(65000-50667) / (68942-50667)]
= 2.78 years
Applying the discounted payback period criterion, Project B will chosen, since the period of recovering investment is lower.
Part 3. NPV = Present value of Cash inflows - Present Value of Cash outflows
Project A = 560361 - 455000 = $105361
Project B = 81463 - 65000 = $16463
Applying NPV criterion, Project A will be chosen, since it has the highest positive NPV.
Year Cash flows (A) Cumulative Cash Flows (A) Cash flows (B) Cumulative Cash flows (B) 1 58000 58000 31000 31000 2 85000 143000 28000 59000 3 85000 228000 25000 84000 4 572000 800000 19000 103000Related Questions
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