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Explanation & Answer
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Outline
I. Net Present Value
A. What is each project’s Net Present Value?
B. According to NPV, which project(s) should be accepted if they are
independent? mutually exclusive?
II. Profitability Index
A. Calculation
B. According to the Profitability Index, which project(s) should be
accepted if they are independent? mutually exclusive?
III. IRR
A. Calculation
B. According to the IRR, which project(s) should be accepted if they
are independent? mutually exclusive?
IV. Payback
A. Calculation
B. According to Payback, which project(s) should be accepted if they
are independent? mutually exclusive?
VII. Solutions
(1) What is each project’s NPV?
Net Present Value (NPV) is a method of ranking investment proposals using the NPV,
which is equal to the present value of future net cash flows, discounted at the cost of
capital.
NPVL=
-200
(1+.10)0
=
$37.56
NPVS=
-200
(1+.10)0
NPVS =
20
(1+.10)1
+
120
(1+.10)2
+
160 _
(1+.10)3
-200 + 18.18 + 99.17 + 120.21
NPVL =
=
+
+
140
(1+.10)1
+
100
(1+.10)2
+
40 _
(1+.10)3
-200 + 127.27 + 82.64 + 37.56
$47.47
(2) According to NPV, which project(s) should be accepted if they are
independent? mutually exclusive?
The rationale behind the NPV method is straightforward: If a project has NPV =
$0, then the project generates exactly enough cash flows (1) to recover the cost of the
investment and (2) to enable investors to earn their required rates of return (the
opportunity cost of capital). If NPV = $0, then in a financial (but not an accounting)
sense, the project breaks even. If the NPV is positive, then more than enough cash flow
is generated, and conversely if NPV is negative.
Consider Project L’s cash inflows, which total $300. They are sufficient (1) to return the
$200 initial investment, (2) to provide investors with their 10% aggregate opportunity
cost of capital, and (3) to still have $37.56 left over on ...
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