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Caledonia is considering two additional mutually exclusive projects. The cash flows associated with these projects are as follows:
| YEAR | PROJECT A | PROJECT B |
| 0 | -$100,000 | -$100,000 |
| 1 | 32,000 | 0 |
| 2 | 32,000 | 0 |
| 3 | 32,000 | 0 |
| 4 | 32,000 | 0 |
| 5 | 32,000 | $200,000 |
The required rate of return on these projects is 11 percent.
a. What is each project’s payback period?
Project A’s payback period is 3.125 years.
Project B’s payback period is 4.5 years.
b. What is each project’s net present value?
Project A NPV is $18,272
Project B NPV is $18,600
b. NPVA
= $32,000 (3.696) – $100,000
= $118,272 – $100,000
= $18,272
NPVB
= $200,000 (0.593) – $100,000
= $118,600 – $100,000
= $18,600
c. What is each project’s internal rate of return (IRR)?
Project A’s IRR is 18%
Project B’s IRR is 15%
c. $100,000 = $32,000 [PVIFAIRRA%,5 yrs]
3.125 = PVIFAIRRA%,5 yrs
IRRA = 18.03%
$100,000 = $200,000 [PVIFIRRB%,5 yrs]
.50 = PVIFIRRB%,5 yrs
IRRB is just under 15% (14.87%).
d. What has caused the ranking conflict?
The main cause of conflict is the difference in the assumptions taken in both decision criteria i.e. NPV and IRR. In IRR the main assumption is that cash flows can be invested again at the internal rate of return in the whole life span of the project. On the other hand according to the assumption of NPV, the investment can be reinvested at the required rate of return or cost of capital in the whole life of project.
e. Which project should be accepted? Why?
As the results have shown that Project B has the highest value for NPV and Project A has a largest value for the rate of return and a lesser payback period, therefore it would be the best option to select. The reason behind this is that NPV is considered to be the preferred criterion to select between alternatives. (Keown, Martin, Petty, & Scott, 2005).
Describe the factors that Caledonia would have to consider if they were doing a lease versus buy for the two projects.
In order to make budget for the new venture, the first thing is to decide that whether to go for leasing or for buying. In the mentioned examples, the decision should be made by analyzing the cash flows. In case of project A, Caledonia must think that there is an instant and stable cash flow. On the other side, there will be no income till five years in Project A. So it becomes evident that it is more appropriate to go with leasing in project A and buying would be feasible n Project B. Moreover resale value should also be considered .If the analysis shows that there would be no remarkable value, the best option would be leasing.
Keown, Arthur J., Martin, John D., Petty, J. William, & Scott, David F. (2005). Financial management: principles and applications (10th ed.). Upper Saddle River, NJ: Pearson Prentice Hall.
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