Question

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Question 2. Assume that you are going to select one of the two projects and applied different selection methods. For each method, explain which project is preferable?

                                                Project X          –             Project Y

Payback Period                     3.8 years           -               2.8 years

IRR                                          %16                    -                 %14             

NPV                                        880 K $               -                610 K $

Answer 1

Method 1: Payback period:

The payback period is the amount of time required to recover the initial investment made in a project. Hence, lesser payback time means the investment made is recovered faster. Thus, a project with a lesser payback period is preferred.

Given in question, Project X has a payback period of 3.8 years and Project Y has a payback period of 2.8 years. Hence, the investment made in Y is recovered faster compared to Project X.

Hence, by the Payback period method, we would select Project Y.

Method 2: IRR

The IRR or internal rate of return is the method in which the project with higher IRR is selected. The IRR is compared with the company's cost of capital. IRR is the percentage where the Net Present Value becomes 0. Suppose the company's cost of capital is X. IF the IRR is higher than X, then only the project is feasible. Thus, the project with higher IRR is preferable.

Given in question, Project X has a higher IRR of 16% compared to Project Y which lower IRR of 14%. Investment X has better returns.

Hence, by the IRR method, we would select Project X.

Method 3: NPV

The net present value of NPV is the value of investment today considering the money which will be received from the project in the future. If you invest X amount today and receive Y amount after 5 years, then the net present value is calculated considering Time value of money for Y amount minus amount invested today. Hence, the Project which has a higher NPV is preferred.

Given in question, Project X has a higher NPV of 880 K$ compared to Project Y which lower NPV of 610 K $. Investment X has a better value of returns which will be received in the future.

Hence, by the NPV method, we would select Project X.

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