As a newly assigned assistant financial analyst at Caledonia Products, Team D has been charged with
calculating the cost of two projects, projected returns, cost of equipment, and finally a recommendation
as to which project to pursue and why. In order to make a recommendation we need all potential cost
incurred, unit price, projected sales, and market information.
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%.
1. What is each project’s payback period?
Project A’s payback period is 3.125 years...
$100,000 / $32,000 = 3.125
Meaning that in 3.125 years, there will be an influx of $100,000.
Project B’s payback period is 4.5 years...
Meaning that in 4.5 years, there will be an influx of $200,000.
2. What is each project’s net present value?
Project A’s net present value would be $18,269 and Project B’s net present value would be $18,690.
3. What is each project’s internal rate of return?
While Project A’s IRR is 18.03%, Project B’s IRR is 14.87%.
d. What has caused the ranking conflict?
The conflict in the rankings is caused by the different assumptions made by the NPV and IRR decision criteria for reinvestment. The Internal Rate of Return way assumes the cash flows can only be reinvested over the life of the project at the internal rate of return. The Net Present Value way assumes that the cash flows can use the rate of return or the cost of capital as a basis for the...