Question:

Anyone know anything about business cash flows?

by Guest58322  |  earlier

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The following is information on the annual cash flows of two mutually exclusive projects under consideration by Wang Food Markets, Inc.

Year A - B

0 $-30,000 $-60,000

1 10,000 20,000

2 10,000 20,000

3 10,000 20,000

4 10,000 20,000

5 10,000 20,000

Wang requires a 14 percent rate of return on projects of this nature.

a. Compute the Net Present Value (NPV) for both projects.

b. Compute the internal rate of return on both projects.

c. Compute the profitability index of both projects.

d. Compute the payback periods for both projects.

e. Which of the two projects, if either, should Wang accept and why?

Could use some help!

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  1. Do you have a finance calculator?  If not, get one.  NPV is easy to calculate by hand but IRR can be tough because it requires a lot of trial and error to find the right number that works.  If you have a finance calculator, though, it is very easy.  The instruction booklet for the calculator will run you through it.  For year A, the answer for NPV is $4,330.81.  This is based on the 14% rate of return on projects of this nature (by the way this 14% is called the company's "cost of capital." a company typically will not pursue a project that does not earn a return equal or higher to the "cost of capital" because it does not add shareholder value.)  For the second project, B, the answer is $8661.62.  Based on the NPV, and assuming they are of equal risk (which they probably are because of the same cost of capital for projects of this nature), Project B would be the better investment.  Just FYI, any project with an NPV greater than zero creates returns higher than the company's cost of capital and would be an investment a company should pursue.  However, since these are mutually exclusive projects, the company will only choose one.  

    IRR is similar to NPV in that it tells an analyst if a project provides returns higher than its cost of capital.  However, instead of giving a dollar amount, IRR gives it via rates of return.  Therefore, if the IRR is greater than the cost of capital (14%), the company should pursue the project.  The IRR of A is: 19.86.  The IRR for B is: 19.86 as well.  There is a reason that they are the same for IRR but different for NPV but the explaination is beyond the scope of this discussion so I won't go into that much detail.  But, you can be sure that, based on these calculations, assuming there aren't any other variables to consider, that plan B is the better investment.  

    I don't know about the profitability index.  I have never worked with such a thing.  Perhaps they want to consider cash flows.  

    The payback period is nothing more than the amount of time it takes for the inflows to equal the initial outflow.  It is 3 years for both projects, by the way.  10,000 * 3 = 30,000 and 20,000 * 3 = 60,000.  This is another method used by companies without an experienced person that is able to do NPV or IRR.  This is not a very accurate method because it does not discount the money back to its present value like NPV and IRR do.  For example, if the cash flows were 20,000, 40,000 and 60,000 for investment A and 60,000, 40,000 and 20,000 for investment B, investment B would be the better investment because receiving 60,000 sooner is better than receiving it later.  Does that make sense?  I can't break it down any easier than that.

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