Question

Calculating Payback Period and NPV Novell, Inc., has the following mutually exclusive projects.

Year   Project A   Project B
0 −$15,000 −$19,000
1 10,400    12,700
2 5,900       6,100
3 2,100   5,300

a.Suppose the company’s payback period cutoff is two years. Which of these two projects should be chosen?
b.Suppose the company uses the NPV rule to rank these two projects. Which project should be chosen if the appropriate discount rate is 15 percent?

Answer 1

(a)

To find the payback period, we create the following table:

Project A ear (t) Net Cash flow Cumulative NCF -15,000 -15,000 10,40 4,60 2 5,900 1300 2,100 3,400 Project B ear (t) Net Cash flow Cumulative NCF 2 6,100 -200 12,700 5,300 5,100 -19,000 -19,000 6,300

The pay-back period is determined from the cumulative net cash flow (NCF) as follows:

Payback period = Full years until recovery + (Uncovered cost at the beginning of the year/Cash flow during the last year)

Thus,

Payback period for Project A = 1+ (4,600/5,900)

Payback period for Project A = 1 + 779

Payback period for Project A = 1.78 years

Similarly,

Payback period for Project B = 2 + (200/5,300)

Payback period for Project B = 2 + 0.0377

Payback period for Project B = 2.04 years

As the company's payback policy is 2 years, Project A shall be chosen as it as a payback of 1.78 years, as compared to Project B's 2.04 years.

(b)

To calculate the NPV of the 2 Projects, we shall use the Financial calculator as follows:

Project A:

CF0 = -15,000 (Press ENTER)

CF1 = 10,400 (Press ENTER)

CF2 = 5,900 (Press ENTER)

CF3 = 2,100 (Press ENTER)

Press NPV

I = 15 (Press ENTER)

Press CPT

NPV = $ -114.49

Similarly for Project B: (Make sure to clear previous work by pressing CF -> 2ND -> CLR WORK)

CF0 = -19,000 (Press ENTER)

CF1 = 12,700 (Press ENTER)

CF2 = 6,100 (Press ENTER)

CF3 = 5,300 (Press ENTER)

Press NPV

I = 15 (Press ENTER)

Press CPT

NPV = $ 140.79

According to the NPV Rule, the company should select the project having a higher positive NPV, in this case Project B shall be chosen.