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Assignment 5 - Investment Criteria

The document analyzes two mutually exclusive investment projects (A and B) based on various criteria: - Project B has a lower payback period than Project A, so payback criterion supports Project B. - Project A has a higher NPV than Project B, so NPV criterion supports Project A. - Project B has a higher IRR than Project A, but IRR criterion is not appropriate for mutually exclusive projects. - Project B has a higher profitability index than Project A, but profitability index may not be a useful measure if capital is not scarce. - Based on the most important NPV criterion, the document concludes that Project A should be chosen for investment.

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rubabshahid2002
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65 views

Assignment 5 - Investment Criteria

The document analyzes two mutually exclusive investment projects (A and B) based on various criteria: - Project B has a lower payback period than Project A, so payback criterion supports Project B. - Project A has a higher NPV than Project B, so NPV criterion supports Project A. - Project B has a higher IRR than Project A, but IRR criterion is not appropriate for mutually exclusive projects. - Project B has a higher profitability index than Project A, but profitability index may not be a useful measure if capital is not scarce. - Based on the most important NPV criterion, the document concludes that Project A should be chosen for investment.

Uploaded by

rubabshahid2002
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Assignment 5 Name:

Consider the following two mutually exclusive projects:

YearCash Flow (A) Cash Flow (B)


0 $ -350,000 $ -50,000
1 45,000 24,000
2 65,000 22,000
3 65,000 19,500
4 440,000 14,600

Whichever project you choose, if any, you require a 15% return on your investment.

Questions:

a-1. What is the payback period for each project?

Project A payback period = 3.398 years

Project B payback period = 2.205 years

a-2. If you apply the payback criterion, which investment will you choose?

We will choose project B as its payback period is lower

b-1. What is the NPV for each project?

NPV (A) = -350000 + 45000(1.15)^(-1) + 65000(1.15)^(-2) + 65000(1.15)^(-3) + 440000(1.15)^(-4)

= $32589.76

NPV (B) = -50000 + 24000(1.15)^(-1) + 22000(1.15)^(-2) + 19500(1.15)^(-3) + 14600(1.15)^(-4)

= $8673.89

b-2. If you apply the NPV criterion, which investment will you choose?

We will choose project A as it has a higher NPV

c-1. The IRR for Project A = 18.14% and the IRR for Project B = 24.08%. Perform calculations to confirm that
these IRR values are correct.
NPV(A) 18.14% = -350000 + 45000(1.1814)^(-1) + 65000(1.1814)^(-2) + 65000(1.1814)^(-3) + 440000(1.1814)^(-4)

= $0

NPV(B) 24.08% = -50000 + 24000(1.2408)^(-1) + 22000(1.2408)^(-2) + 19500(1.2408)^(-3) + 14600(1.2408)^(-4)

= $0

The NPV using the respective IRR as the interest rate returns $0 for both projects hence, the IRRs given are
correct

c-2. If you apply the IRR criterion, which investment will you choose?

I will choose project B, as it has a higher IRR hence the project will return a positive NPV for a higher range of
interest rates

c-3. Is it appropriate to use IRR in this situation? Why?

It is not appropriate to use IRR in this situation as the projects are mutually exclusive

d-1. What is the profitability index for each project?

PI (A) = [45000(1.15)^(-1) + 65000(1.15)^(-2) + 65000(1.15)^(-3) + 440000(1.15)^(-4)] / 350000

= 382589.89 / 350000

= 1.093

PI (B) = [24000(1.15)^(-1) + 22000(1.15)^(-2) + 19500(1.15)^(-3) + 14600(1.15)^(-4)] / 50000

= 58673.89 / 50000

= 1.173

d-2. If you apply the profitability index criterion, which investment will you choose?

I will choose project B as it has a higher profitability index

d-3. Is it appropriate to use the profitability index in this situation? Why?

If capital is not scarce, profitability index is not a useful measure, hence if capital is scarce, it is appropriate to
use it, else it is not.
e. Based on your answers in (a) through (d), which project will you finally choose?

I will choose project A, as although almost every investment criteria supports project B, the most important,
NPV supports the investment of project A

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