You are considering the following two mutually exclusive projects. Both projects

Question

You are considering the following two mutually exclusive projects. Both projects will be depreciated using straight-line depreciation to a zero book value over the life of the project. Neither project has any salvage value

Project A Project B

Year cash flow Year cash flow

0 -$45,000 0 -$40,000

1 $17,500 1 $8,200

2 $18,000 2 $14,600

3 $22,500 3 $36,800

                                                Project A               Project B

Required rate of return 8% 12%

required payback period 2years 2years

Required accounting return 8.5% 9.5%

a. (5 points) What is the NPV for each of the projects? Which project should be accepted if NPV method is applied? Explain why.

b. (5 points) What is the IRR for each of the projects? Which project should be accepted if IRR method is applied? Explain why.

c. (5 points) What is the payback period for each of the projects? Which project should be accepted if payback period method is applied? Explain why.

d. (5 points) What is the discounted payback period for each of the projects? Which project should be accepted if discounted payback period method is applied? Explain why.

e. (5 points) What is the profitability index for each of the projects? Which project should be accepted if profitability index method is applied? Explain why.

f. (5 points) What is the average accounting return (AAR) for each of the projects, assuming that cash flows occurring after year 0 are net income? Which project should be accepted if AAR method is applied? Also, assume that the target AAR is 10%.

g. (5 points) Define and find the crossover rate.

h. (5 points) Sketch the NPV profile. Plot all the relevant coordinates (i.e., the points on the x and y axis; and the cross-over rate) on the graph.

Explanation / Answer

A The NPV of the projects

= -45000 + 17500/1.08 + 18000/1.08 + 22500/1.08

=4163.91

NPV for project B

= 4601.76

NPV for Project B > NPV for Project A

b) IRR for projects

IRR a =13%

IRR B = 18%

IRR B > IRR A

c) Payback period

= 2.42 years

It is the time in which original cashflows are returned

PAyback period =2.46 years

It is the time in which original cashflows are returned

Discounted payabck period

FOr discounted payabck period we calculate first the present value of the cashflows individually

For project A would be

17861.23

= it will give payback period of 2.09 years

29213.03

This will give payback period of 2.31 years

-45000 16203.7 15432.1

17861.23

= it will give payback period of 2.09 years

-40000 7592.593 12517.15

29213.03

This will give payback period of 2.31 years

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