Question - NPV vs. Payback Method vs. Profitability Index
Alfred Stein is about to invest $1,000. Alfred is a very cautious man and would like to have some expert advice on which two projects is best for him. He has not told you his exact cost of capital because he likes to keep such information private, but he has told you to consider 8 percent, 10 percent, and 12 percent in your calculations. He has also told you that the salesperson from whom he expects to purchase his equipment has given him the following expected cost savings patterns:
Year Project 1 Project 2
1 $600 $300
2 $600 $600
3 $600 $800
4 $600 $700
A. Calculate the present value of each project at each of Alfred's potential costs of capital and indicate which project is acceptable at each.
B. Calculate the payback period for each project. Does your recommendation to Alfred change?
C. Calculate the profitability index for each project, using a cost of capital of 10 percent. Which project would you recommend Alfred pursue?
In addition to answering letters A through C, use Excel to calculate the IRR for each project and discuss your results.