A person just bought a house for $150,000. however, he also has to pay another $2,000 for his house every year.
2 answers:
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Answer:
A) Project A = 0.83 year
B) NPV of Project B = $14,609.66
C) Answer B
Explanation:
Requirement A
We know,
Payback period = Last year with negative cumulative cash flows + (Absolute value of last year's cumulative cash flow ÷ Cash flow of the following year's negative cumulative cash flow)
Or, Payback period = A + ( B ÷ C)
Project A Project B
Year Cash Flow Cumulative Cash Flow Cash Flow Cumulative Cash Flow
0 (A) -$10,000 -$10,000 (B) -$10,000 -$10,000 (B)
1 $12,000 (C) 2,000 $10,000(C) 0
2 8,000 10,000 6,000 6,000
3 6,000 16,000 16,000 22,000
Payback period for project A = 0 + ($10,000 ÷ 12,000) = 0 + 0.833 = 0.83 year
Payback period for project B = 0 + ($10,000 ÷ 10,000) = 0 + 1 = 1 year
X-treme Vitamin Company should choose project A because it can return the investment earlier than project B.
Requirement B
We can use excel to find the Net Present Value for both the projects with a cost of capital of 10%.
The following image shows the NPV for project A and B.
From the calculation of NPV, X-treme Vitamin Company should choose project B as that project yields more present cash flows.
Requirement C
A firm should generally have more confidence in answer b because money can produce more logical sense than a year. Yes, it is easy to understand how many years a company will need to get back its cash flow. Still, the present value of cash flows provides a more specific evaluation of how to utilize the initial investment.
