Question

Britney Javelin Company is considering two Investments, both of which cost $44,000. The cash flows are as follows: Use Appendix 8 and Appendix D.

Year Project A Project B
1 $22,000 $21,000
2 17,600 17,000
3 13,000 15,000

a. Calculate the payback period for project A and project B. (Round the final answers to 2 decimal places.)

Payback period
Project A years
Project B years

b-1. Calculate the NPV for project A and project B. Assume a cost of capital of 8 percent. (Round "PV Factor" to 3 decimal places. Round the Intermediate and final answers to the nearest whole dollar.)

Net present value
Project A $
Project B $
b-2 Which of the two projects should be chosen based on the NPV method?
O Project A
O Project B
O Both
c. Should a firm normally have more confidence In answer derived based on NPV method or Payback method?
O NPV method
O Pay back method

Answer 1

Answer and Explanation:

a. To calculate the payback period, we need to determine the number of years it takes to recover the initial investment. We subtract the cash flows from the initial investment until the cumulative cash flows equal or exceed the initial investment.

For Project A:

Initial Investment = $44,000

Year 1 Cash Flow = $22,000

Year 2 Cash Flow = $17,600

Year 3 Cash Flow = $13,000

Cumulative Cash Flow:

Year 1: $22,000

Year 2: $22,000 + $17,600 = $39,600

Year 3: $39,600 + $13,000 = $52,600

The payback period for Project A is 2 years.

For Project B:

Initial Investment = $44,000

Year 1 Cash Flow = $21,000

Year 2 Cash Flow = $17,000

Year 3 Cash Flow = $15,000

Cumulative Cash Flow:

Year 1: $21,000

Year 2: $21,000 + $17,000 = $38,000

Year 3: $38,000 + $15,000 = $53,000

The payback period for Project B is 3 years.

b-1. To calculate the NPV, we need to discount the future cash flows to their present value and then subtract the initial investment.

PV Factor at 8%:

Year 1: 1 / (1 + 8%)^1 = 0.926

Year 2: 1 / (1 + 8%)^2 = 0.857

Year 3: 1 / (1 + 8%)^3 = 0.794

For Project A:

Year 1 PV = $22,000 * 0.926 = $20,372

Year 2 PV = $17,600 * 0.857 = $15,083

Year 3 PV = $13,000 * 0.794 = $10,322

NPV of Project A = ($20,372 + $15,083 + $10,322) - $44,000 = -$42,223

For Project B:

Year 1 PV = $21,000 * 0.926 = $19,446

Year 2 PV = $17,000 * 0.857 = $14,569

Year 3 PV = $15,000 * 0.794 = $11,910

NPV of Project B = ($19,446 + $14,569 + $11,910) - $44,000 = -$44,075

b-2. Based on the NPV method, we should choose Project A because it has a higher NPV (-$42,223) compared to Project B (-$44,075).

c. A firm should normally have more confidence in the answer derived based on the NPV method rather than the payback method. The NPV method considers the time value of money and provides a more comprehensive measure of profitability. It takes into account the discount rate and calculates the present value of all cash flows, giving a more accurate representation of the investment's value. On the other hand, the payback method only focuses on the time required to recover the initial investment without considering the profitability beyond that point.