Finance - Investment appraisal
Finance - Investment Appraisal
Payback period for Option A:
Payback period for Option A = [2 + (90000/120000)] years
[2 + 0.75] years
2.75 years = 2 years and 270 days
Payback period for Option B:
The Payback period for Option A = [5 + (80000/430000)] years
[5 + 0.19] years
5.75 years = 2 years and 70 days
NPV and IRR for the option A:
NPV for option A = Sum of all cash inflows and outflows = +64280
IRR for option A = lower NPV% + (higher NPV % - lower NPV %)x ( lower NPV / Lower NPV – Higher NPV)
= 0.1 + (12% - 10%) x (86200 / 86200 – 64280)
= 0.1 + 0.07 = 0.107
= 10.7%
NPV and IRR for the option B:
NPV for option B = Sum of all cash inflows and outflows = (102150)
IRR for option B = lower NPV% + (higher NPV % - lower NPV %) x (lower NPV / Lower NPV – Higher NPV)
= 0.1 + (12% - 10%) x (491905 / 491905 + 102150)
= 0.1 + 0.02 = 0.12
= 12%
Profitability Index for Option A and B
Equivalent annual annuity (EAA):
Formula = EAA = [ NPV x discounting factor] / [1 – (1+r)-n ]
Where r = discounted rate
n = number of years
Decision
Option A must be accepted on the basis of NPV and IRR. The NPV for the option A is positive and NPV for the option B is negative, which is a main signal to the management. Moreover, the IRR of the option A is very close to the discounting factor which is 10%. However, the IRR for the option B is exactly 12%, which is the discounted factor as well. The payback period of project B and negative NPV for option B shows that the management must accept the option A.
The biggest drawback of the payback period method is that it ignores the time value of money. Moreover, it also ignores the cash flows after the initial investment is recovered. However, its main benefit is that it provides the estimated time frame for the redemption of the initial investment and can be used for the startup screening for the project.
The main disadvantage of IRR is that it does not provide the absolute profitability of the projects. Moreover, its representation provides an estimated value for the management and it is complex to calculate. The main advantage of the IRR is that it considers the time value of money and all the relevant cash flows for the projects.
References
Equivalent annual annuity approach - eaa.. Retrieved from
http://www.investopedia.com/terms/e/equivalent-annual-annuity-approach.asp
Advantages of the irr method.. Retrieved from
https://www.boundless.com/finance/capital-budgeting/internal-rate-of-return/advantages-of-the-irr-method/
