Question

Senior management asks you to recommend a decision on which project(s) to accept based on the cash flow forecasts provided.The firm uses a 3-year cutoff when using the payback method. The hurdle rate used to evaluate capital budgeting projects is 15%.

Assume the projects are independent and answer the following:

• Calculate the payback period for each project.
• Which project(s) would you accept based on the payback criterion?
• Calculate the internal rate of return (IRR) for each project.
• Which projects would you accept based on the IRR criterion?
• Calculate the net present value (NPV) for each project.
• Which projects would you accept based on the NPV criterion

	Project A	Project B	Project C
Year 0	-30,000	-20,000	-50,000
Year 1	0	4,000	20,000
Year 2	7,000	5,000	20,000
Year 3	20,000	6,000	20,000
Year 4	20,000	7,000	5,000
Year 5	10,000	8,000	5,000
Year 6	5,000	9,000	5,000

Answer 1

	Project A		Project B		Project C
	Cash inflow	Cummulative Cash inflow	Cash inflow	Cummulative Cash inflow	Cash inflow	Cummulative Cash inflow
Year 0	$               (30,000)	$              (30,000)	$            (20,000)	$            (20,000)	$     (50,000)	$              (50,000)
Year 1	$                          -	$              (30,000)	$                 4,000	$            (16,000)	$        20,000	$              (30,000)
Year 2	$                   7,000	$              (23,000)	$                 5,000	$            (11,000)	$        20,000	$              (10,000)
Year 3	$                 20,000	$                (3,000)	$                 6,000	$              (5,000)	$        20,000	$                10,000
Year 4	$                 20,000	$                17,000	$                 7,000	$                2,000	$          5,000	$                15,000
Year 5	$                 10,000	$                27,000	$                 8,000	$              10,000	$          5,000	$                20,000
Year 6	$                   5,000	$                32,000	$                 9,000	$              19,000	$          5,000	$                25,000
Pay back period between the	Year 3 to 4		Year 3 to 4		Year 2 to 3
Amount required to recover		$                   3,000		$                5,000		$                10,000
Divided by:Cash flow during the year		$                20,000		$                7,000		$                20,000
Fraction in year		0.15		0.71		0.50
Pay back period in a years		3.15		3.71		2.50
Which project(s) would you accept based on the payback criterion?
Project C would you accept based on the payback criterion						Project C

Project A
	Cash flow	Discount factor @ 15%	Present value
Year 0	$       (30,000)	1.000000	$              (30,000)
Year 1	$                   -	0.869565	$                          -
Year 2	$            7,000	0.756144	$                   5,293
Year 3	$         20,000	0.657516	$                 13,150
Year 4	$         20,000	0.571753	$                 11,435
Year 5	$         10,000	0.497177	$                   4,972
Year 6	$            5,000	0.432328	$                   2,162
Net Present value			$                   7,012
Project B
	Cash flow	Discount factor @ 15%	Present value
Year 0	$       (20,000)	1.000000	$              (20,000)
Year 1	$            4,000	0.869565	$                   3,478
Year 2	$            5,000	0.756144	$                   3,781
Year 3	$            6,000	0.657516	$                   3,945
Year 4	$            7,000	0.571753	$                   4,002
Year 5	$            8,000	0.497177	$                   3,977
Year 6	$            9,000	0.432328	$                   3,891
Net Present value			$                   3,075
Project C
	Cash flow	Discount factor @ 15%	Present value
Year 0	$       (50,000)	1.000000	$              (50,000)
Year 1	$         20,000	0.869565	$                 17,391
Year 2	$         20,000	0.756144	$                 15,123
Year 3	$         20,000	0.657516	$                 13,150
Year 4	$            5,000	0.571753	$                   2,859
Year 5	$            5,000	0.497177	$                   2,486
Year 6	$            5,000	0.432328	$                   2,162
Net Present value			$                   3,171
Which projects would you accept based on the NPV criterion
All projects have Positive Net present value.			All projects