Question

Comparing Investment Criteria. Halo Project, a game manufacturer, has a new idea or as an interactive DVD, but not both. Consider the following cash flows of the two project is 10 percent.

Year	Board Game	DVD
0	-$750	-$1,800
1	600	1300
2	450	850
3	120	350

1. Based on the payback period rule, which project should be chosen?

2. Based on the NPV, which project should be chosen?

3. Based on the IRR, which project should be chosen? I need detail solution
4. Based on the incremental IRR, which project should be chosen?  I need detail solution

Answer 1

Detailed answer is as below

Question A - Payback Period
		Board Game		DVD
1) Payback Period is the time taken to get back the investment in an asset from its net cash flows. 2) An investment is considered better if the payback period is shorter so that the initial investment is got back at the earliest. The risk is for a short period of time.	Year	Cash Flow	Net Investment	Cash Flow	Net Investment
	0		$             (750.00)		$          (1,800.00)
	1	$        600.00	$             (150.00)	$ 1,300.00	$             (500.00)
	2	$        450.00	$                300.00	$     850.00	$                350.00
	3	$        120.00	$                420.00	$     350.00	$                700.00

Ans - In Board game project, the initial investment of $750 is got back at the end of 1.4 years ($ 600 in first year and ($150/$450) i.e 4 months in the second year. In DVD project, the initial investment of $1800 is got back at the end of 1.58 years ($ 1300 in first year and ($500/$850) i.e 5.8 months in the second year. Since the payback period of Board game is shorter (1.4 years), Board game project is considered better.

Question B - NPV Method
	Year	PV of Cash flow of Board Game		PV of Cash flow of DVD
1) NPV is the difference between the present value of all future cash inflows and the present value of the initial investment (cash outflow). 2) If the net present value of the cash inflows is greater than the present value of the initial investment, then there is a positive NPV. Else there is a negative NPV and hence the project sall not be acceptable. 3) The interest rate for discount in our example is 10%		Formula	Calculation	Formula	Calculation
	0	-	$             (750.00)	-	$              (1,800.00)
	1	=Cash flow/(1+rate)^number of years	$                545.45	=Cash flow/(1+rate)^number of years	$                 1,181.82
	2	=Cash flow/(1+rate)^number of years	$                371.90	=Cash flow/(1+rate)^number of years	$                    702.48
	3	=Cash flow/(1+rate)^number of years	$                  90.16	=Cash flow/(1+rate)^number of years	$                    262.96
		Sum of all Cash flows	$                257.51	Sum of all Cash flows	$                    347.26

Ans - In Board game project, the NPV is $ 257.51 whereas for the DVD project the NPV is 347.26. Since the NPV for the DVD project is higher than the Board Game project, the DVD project is better and feasible.

Question C - IRR Method
	Year	PV of Cash flow of Board Game		PV of Cash flow of DVD
1) In the above NPV method, we found the NPV for the expected rate of return of 10%. The NPV was $ 257.51 and $347.26 for the two projects respectively. To Identify IRR, we have to arrive at the interest rate at which the NPV of the project becomes ZERO. 2) IRR or internal rate of Return is the rate of return at which the NPV of the project is equal to Zero.		Formula	Calculation	Formula	Calculation
	0	-	$             (750.00)	-	$              (1,800.00)
	1	=Cash flow/(1+rate)^number of years	$                448.48	=Cash flow/(1+rate)^number of years	$                 1,054.28
	2	=Cash flow/(1+rate)^number of years	$                251.42	=Cash flow/(1+rate)^number of years	$                    559.04
	3	=Cash flow/(1+rate)^number of years	$                  50.11	=Cash flow/(1+rate)^number of years	$                    186.68
		Sum of all Cash flows	$                    0.00	Sum of all Cash flows	$                         0.00
		IRR	33.79%	IRR	23.31%

Ans : Since the IRR of Board Game is higher than the IRR of DVD project, Board Game project is better of the two projects.

Question D - Incremental IRR Method
	Year	Board Game	DVD	Incremental Cash Flow	PV of Incremental Cash flow
1) In general, in cases where the initial investment in two projects are vastly different .. Egample double, in such cases we identify the incremental IRR. 2) Incemental IRR is the internal rate of return of the incremental cash flows of the two projects. 3) Identify the incremental cash flows of the two projects every year and solve for NPV and IRR as per our question B and C. 3) If te Incremental IRR is higher than the minimum rate of return that you expect in your project, then the roject with a higher investment should be chosen.					Formula	Calculation
	0	$     (750.00)	$     (1,800.00)	$   (1,050.00)	-	$     (1,050.00)
	1	$       600.00	$       1,300.00	$         700.00	=Cash flow/(1+rate)^number of years	$           636.36
	2	$       450.00	$           850.00	$         400.00	=Cash flow/(1+rate)^number of years	$           330.58
	3	$       120.00	$           350.00	$         230.00	=Cash flow/(1+rate)^number of years	$           172.80
					Sum of all Cash flows (NPV)	$             89.74
					IRR	15.86%

Ans : Since the IRR of 15.86% is more than the expected rate of return (10%), the DVD project with a higher investment should be chosen.