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?
b. What is each project’s net present value?
c. What is each project’s internal rate of return?
d. What has caused the ranking conflict?
e. Which project should be accepted? Why?

MY ANSWERS:

a. What is each project’s payback period?
Project A = 100000/32000 = 3.125 year
Project B = 4.5 years

b. What is each project’s net present value?
5
Project A = -100000 + ∑ 32000 (1.15) pwr t = $18268
T=0

Project B = -100000 + 200000(1.15) pwr 5 = -$564

c. What is each project’s internal rate of return?
5
Project A 0 = -100000 + ∑ 32000 (1+r) pwr t
T=0
R = 18.03%

Project B 0 = -100000 + 200000(1+r) pwr 5

R = 14.87%

d. What has caused the ranking conflict?

Ranking conflict is caused because Project A generates the cash flow consistently throughout the project life whereas Project B generates it only at the end of project life.

e. Which project should be accepted? Why?

Project A should be accepted because it has positive NPV and higher IRR.

You're generally on the right track throughout. Some thoughts...

a) I agree with those payback computations if we assume that each year's cash flows come in evenly throughout the year. If that's the case, then A's outlay is fully recovered one-eighth of the way through the 4th year, and B's is recovered halfway through the 5th year. But in the IRR / PV comps, it's usually assumed that all cash flows occur on the last day of each year. Under this viewpoint, A's and B's cost would be recovered on the last day of the 4th year and 5th year, respectively. That doesn't mean that the payback computations must adopt this same 'last-day-of-the-year' assumption; I'd just suggest consulting your text for the methodology it's looking for.

Your response in (b) gets a wee bit dizzy, but I can see what you hand in mind. You originally stated that the discount rate is 11%, but you're showing 15% in your calcs. However, the answer you arrived at for Project A is the correct one for a 11% discount rate. Your NPV is also correct for Project B, using 15%.

Your IRR calcs in (c) are correct and correct (nice job).

The (d) question indicates the book already knew you'd have a ranking conflict. Your answer is starting down the right path, but you need more. It'd be easy to conjure up two sets of cash flows in which a quicker return means a lower NPV. At the heart of the conflict is this concept: The implied reinvestment rate is 11%. While it's true that A has the superior yield, it's unfortunately transferring some of its cash back to you each year, leaving you to reinvest it at 11%. B, on the other hand--while it has a slightly lower yield than A--lets you leave all of your investment baking in the oven at 14.9% for the entire 5-year period. In other words, having all of your investment cooking at 14.9% is superior to having some of it earning 18% and the rest earning just 11% (with the 18%-vs-11% mix getting less favorable each year).

But note that if the implied reinvestment rate was higher than the projects' yields, then the faster payout would be preferable. That's why your proposed answer needs to be filled out a bit; it's correct in certain situations, but not always.

By implying that A wins on both counts, your (e) answer contradicts the "ranking conflict" of (d). Recompute B's NPV using 11%. Then consult your text to see which method is generally considered superior--I guarantee there's a little discussion in there on that topic.

Good luck with it!

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?
b. What is each project's net present value?

My A project payback period is the amount of time in which it takes a Capital Budgeting project to
recover its initial cost. A payback period= (last year with a negative NCF)+(Absolute value of NCF in that year)
(Total cash flow in the following year)
Project A has a payback period of 100000/32000= 3.125 years

Project B has a payback period of 100,000/200,000 = 0.5 years
One of my teammates is quetioning me on project B's payback period? Where am I going wrong?