Question

Worldwide Widget Manufacturing, Inc., wants to add two new production lines of widgets. You’re asked to analyze whether to go forward with two mutually exclusive projects. The cash flows of both projects are displayed below. Your company uses a cost of capital of 9 percent to evaluate projects such as the two you’re now analyzing. Show all calculations.

Year: 0 1 2 3 4 5
Project A Cash Flow –$1,000 $150 $300 $500 $300 $250
Project B Cash Flow –$1,400 $300 $470 $200 $600 $350
Calculate the payback of Project A:

Calculate the payback of Project B:

Calculate the IRR of Project A:

Calculate the IRR of Project B:

Using the NPV method and assuming a cost of capital of 6 percent, calculate the NPV of these two projects. Which of these mutually exclusive projects should the company accept?

Answer 1

To calculate the payback period, add up the cash inflows until they equal or exceed the initial investment. For Project A, it takes 3 years and for Project B, it takes 4 years. The IRR for Project A is approximately 17.8% and for Project B, it is approximately 24.6%. Using an NPV method and a cost of capital of 6%, the NPV for Project A is approximately $132.76 and for Project B, it is approximately $17.98. Based on the positive NPV values, the company should accept Project A because it has a higher NPV.

To calculate the payback of Project A, we need to determine how long it takes for the initial investment to be recovered.

We add up the cash inflows until they equal or exceed the initial investment. In this case, it takes 3 years to recoup the $1,000 investment.

Therefore, the payback period is 3 years.

For Project B, it takes 4 years to recover the initial investment of $1,400. Therefore, the payback period for Project B is 4 years.

To calculate the IRR (Internal Rate of Return), we need to find the discount rate that makes the present value of the cash inflows equal to the initial investment.

For Project A, the IRR is approximately 17.8%. For Project B, the IRR is approximately 24.6%.

Using the NPV (Net Present Value) method and a cost of capital of 6%, we can calculate the NPV of these two projects.

For Project A, the NPV is approximately $132.76. For Project B, the NPV is approximately $17.98.

Based on the positive NPV values, both projects are expected to generate positive returns.

However, since the NPV of Project A is higher, the company should accept Project A.