Solution 14.5
 
 

a) Determine which project to recommend according to:

  1. The payback method.
  2. The net present value method.
(Your recommendation should be clearly explained for both methods)

1)   Payback method

 

 

Project A

 

Project B

 

 

Year

Cash Flows

Cumulative Cash Flows

 

Cash Flows

Cumulative cash flows

 

0

-70,000

-70,000

 

-70,000

-70,000

 

1

10,500

-59,500

 

8,900

-61,100

 

2

15,600

-43,900

 

8,560

-52,540

 

3

20,567

-23,333

 

24,066

-28,474

 

4

25,671

 

 

30,200

 

 

5

22,700

 

 

38,131

 

 

 

 

 

 

 

 

 

Payback

3 years + {12 x 23333/25671}

3 years + [12 x 28474/30200]

 

 

 

 

 

 

 

 

3 years + 10.9 months

3 years + 11.31 months

 

 

 

 

 

 

 
                   

 

 

         2)    Net present value

 

 

Project A

 

 

Project B

 

 

Year

Cash Flows

Disc 10%

Present Value

 

Cash Flows

Disc 10%

Present Value

0

-70,000

1

-70000

 

-70,000

1

-70000

1

10500

0.909

9544.5

 

8900

0.909

8090.1

2

15600

0.826

12885.6

 

8560

0.826

7070.56

3

20567

0.751

15445.82

 

24066

0.751

18073.57

4

25671

0.683

17533.29

 

30200

0.683

20626.6

5

22,700

0.621

14096.7

 

38,131

0.621

23679.35

NPV

 

 

-494.09

 

 

 

7540.18

 

 

 

 

 

 

 

 
                 

 

Based on the net present value approach it is clear that project B should be recommended at the expense of project A. Project B is projected to provide a positive net present value. This means that the present value of the cash inflows are greater than the present value of the cash outflows with all cash flow discounted at the cost of capital. Thus the project should provide a return in excess of the minimum required return. Project A is projected to provide a negative net present value and thus this project is expected to provide a return less than the minimum required return.

The payback approach simply asks the question, which project will be first to payback the initial capital outlay. In this case there is very little difference between the projects with the payback for project A at 3 years and 10.9 months whereas project B is at 3 years and 11.3 months. Overall the recommendation should be based on the net present value approach as it focuses on the total cash flows of each projects as well as taking the time value of money into account. Thus the recommendation should be project B. 

 b)      Briefly list any other factors that should be taken into account before a decision is made 

·         Management should assess the uncertainty in its forecast figures through the use of sensitivity analysis. Sensitivity analysis should he applied to all the variables that are inputs to for example the net present value decision model. Thus applying sensitivity analysis to the cost of capital as well as the forecast cash flows

·         Management should try and ascertain the non quantifiable factors which may effect the business based on their decision.

·         Management should try and assess are their any other investment opportunities available