ABC is evaluating a new project. You are the manager and need to make a decision

Question

ABC is evaluating a new project. You are the manager and need to make a decision: Calculate all four capital budgeting techniques A. Net present value, B. Internal rate of return (IRR), C. Payback period for each of the following projects. D. Profitability Index. The firm requires a rate of return of 14 percent Which project(s) should be purchased if they are independent? Which project(s) should be purchased it they are mutually exclusive? Year Project Alpha Project Beta 0 $(270,000) $(300,000) 1 120,000 0 2 120,000 (80,000) 3 120,000 555,000

Explanation / Answer

Project Alpha:

Present value of cash inflows = 120,000 x PVAi=14%, n=3 = 120,000 x 2.322 = $ 278,640

A.NPV = $ 278,640 - 270,000 = $ 8,640

B.Internal rate of return = 16%

C. Payback period = 270,000 / 120,000 = 2.25 years

D. Profitability Index = Present value of cash inflows / Present value of cash outflows = 278,640 / 270,000 = 1.032

Project Beta:

A. NPV = 0 x 0.877 + (80,000) x 0.769 + 555,000 x 0.675 - 300,000 = $ 13,105

B. Internal Rate of Return: 16%

C. Payback period: 3 years

D. Profitability Index = 436,145 / 300,000 = 1.45

Project Alpha should be purchased. Even though the NPV, payback period and PI all are better for Project Beta, the cash flows of Project Alpha are stable, and not as volatile as those of Project Beta. Both the projects have the same IRR.

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