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The manager of a local company has to choose between the two projects below
The manager of a local company has to choose between the two projects below. The required rate of return is 10% Year Project A Project B 0 -359000 -276000 1 95000 40000 2 108000 83000 3 90000 105000 4 80000 128000 5 20000 148000 What is payback period for each project? What is the IRR for each project? Which project shall the manager choose?
Expert Solution
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Part 1) Payback period
Project A:
Year Opening Balance CF Closing Balance 1 $ 395,000.00 $ 95,000.00 $ 264,000.00 2 $ 300,000.00 $ 108,000.00 $ 156,000.00 3 $ 192,000.00 $ 90,000.00 $ 66,000.00 4 $ 102,000.00 $ 80,000.00 $ -14,000.00 5 $ 22,000.00 $ 20,000.00 $ -34,000.00 Opening balance of year 1= Cost
Opening balance = previous year's closing balance for all years after year 1
Closing balance = Opening balance - CF
The closing balance of year 3 was 66000 and the CF for year 4 was 80000 so the portion of year during which the 66000 is recovered is 66000/80000= 0.825
So the payback period is 3.825 yearsProject B:
Year Opening Balance CF Closing Balance 1 $ 276,000.00 $ 40,000.00 $ 236,000.00 2 $ 236,000.00 $ 83,000.00 $ 153,000.00 3 $ 153,000.00 $ 105,000.00 $ 48,000.00 4 $ 48,000.00 $ 128,000.00 $ -80,000.00 5 $ -80,000.00 $ 148,000.00 $ -228,000.00 Opening balance of year 1= Cost
Opening balance = previous year's closing balance for all years after year 1
Closing balance = Opening balance - CF
The closing balance of year 3 was 48000 and the CF for year 4 was 128000 so the portion of year during which the 48000 is recovered is 48000/128000= 0.32
So the payback period is 3.32 yearsDecision: Project B should be selected
Part 2) IRR is the rate at which NPV = 0
IRR can be calculated using either a financial calculator or excel or through hit and trial:Project A:
Using Excel we get the IRR =3.65% rounded to two decimal places
Year CF Discount Factor Discounted CF 0 $ -359,000.00 1/(1+0.0365413643846259)^0= 1 1*-359000= $ -359,000.00 1 $ 95,000.00 1/(1+0.0365413643846259)^1= 0.964746834 0.964746834385794*95000= $ 91,650.95 2 $ 108,000.00 1/(1+0.0365413643846259)^2= 0.930736454 0.930736454457411*108000= $ 100,519.54 3 $ 90,000.00 1/(1+0.0365413643846259)^3= 0.897925048 0.897925048085246*90000= $ 80,813.25 4 $ 80,000.00 1/(1+0.0365413643846259)^4= 0.866270348 0.866270347655953*80000= $ 69,301.63 5 $ 20,000.00 1/(1+0.0365413643846259)^5= 0.835731576 0.835731575623362*20000= $ 16,714.63 NPV = Sum of all Discounted CF $ 0.00 Project B:
Using Excel we get the IRR =19.58% rounded to two decimal places
Year CF Discount Factor Discounted CF 0 $ -276,000.00 1/(1+0.195842170584978)^0= 1 1*-276000= -276,000.00 1 $ 40,000.00 1/(1+0.195842170584978)^1= 0.836230754 0.83623075402235*40000= 33,449.23 2 $ 83,000.00 1/(1+0.195842170584978)^2= 0.699281874 0.699281873972789*83000= 58,040.40 3 $ 105,000.00 1/(1+0.195842170584978)^3= 0.584761009 0.584761008746427*105000= 61,399.91 4 $ 128,000.00 1/(1+0.195842170584978)^4= 0.488995139 0.488995139266895*128000= 62,591.38 5 $ 148,000.00 1/(1+0.195842170584978)^5= 0.408912774 0.40891277402242*148000= 60,519.09 NPV = Sum of all Discounted CF 0.00 Decision: Project B should be selected as it has a higher IRR
Part 3) Based on the two techniques, IRR is superior as it considerstime value of money, however, both these methods are not comprehensive enough as NPV method is. Based on these two merthods, Project B should be selected as it has a higher IRR
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