Question

X-treme Vitamin Company is considering two investments, both of which cost $18,000. The cash flows are as follows:

Year Project A Project B
1 $20,000 $18,000
2 8,000 7,000
3 7,000 12,000

a. Calculate the payback period for Project A and Project B.
b. Which of the two projects should be chosen based on the payback method?
c. Calculate the net present value for Project A and Project B. Assume a cost of capital of 8 percent.
d. Which of the two projects should be chosen based on the net present value method?
e. Should a firm normally have more confidence in the payback method or the net present value method?

Answer 1

A. Project A = 0.9

Project B = 1

B. Project A should be chosen

C for project A, NPV = $12,934.05

For project B ,NPV = $14,194.03

D. Project B would be chosen

E. Net present value

Step-by-step explanation:

The payback period measures how long it takes to recover the amount invested in a project.

For project A, the pay back period = 18,000 / 20,000 = 0.9 year

For project B, the payback period is 18,000 / 18,000 = 1 year

Project A should he chosen because the payback period is shorter

The net present value is the present value of after tax cash flows from an investment less the amount invested.

The net present value can be calculated using a financial calculator:

For project A ,

Cash flow for year zero = -$18,000

Cash flow for year 1 = $20,000

Cash flow for year 2 = $8,000

Cash flow for year 3 = $7,000

Discount rate = 8%

NPV = $12,934.05

For project B,

Cash flow for year zero = -$18,000

Cash flow for year 1 = $18,000

Cash flow for year 2 = $7,000

Cash flow for year 3 = $12,000

Discount rate = 8%

NPV = $14,194.03

Project B should be chosen based on NPV because its NPV is greater than that of project A.

A firm should have more confidence in Npv because the NPV calculates using all cash flows while pay back period is only interested in the cash flows up until the amount invested in the project is recovered.

I hope my answer helps you