Visionary Inc. is examining two projects, A and B. Project A has a lower initial investment than project B and is expected to generate a steady stream of cash flows over its economic life. Project B is expected to generate lower cash flows in earlier years and higher cash flows in later years relative to project A. Details regarding the initial investment projected at time 0 and subsequent cash flows for the two projects are provided below:
Assume that the cost of capital for both projects is 10%.
a. Calculate the payback and discounted payback period for each project. Which project appears to be preferable using these methods? Give reasons. What are the major flaws in these methods?
b. Calculate the net present value of each project. Which project is preferable using this method?
c. Calculate the profitability index for each project. Which project would you select using this method?
d. Calculate the IRR for each project. Which project would you choose using the IRR rule? Try to calculate the IRR for project B using interpolation and see whether you are able get an answer close to the one you would get using a financial calculator or a software package.
e. Does the question provide sufficient information to help us determine whether the projects are independent or mutually exclusive? How would you distinguish between the two categories?
f. Are you able to reach the same decision by applying the different decision criteria? If not, which criterion would you rely on? Why?