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25 October, 12:11

Farmer Co. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the shorter payback, some value may be forgone. How much value will be lost in this instance? Note that under some conditions choosing projects on the basis of the shorter payback will not cause value to be lost. r = 10.25%Year 0 1 2 3 4CFS - $950 $500 $800 $0 $0CFL - $2,100 $400 $800 $800 $1,000a. $24.14b. $26.82c. $29.80d. $33.11e. $36.42

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  1. 25 October, 12:54
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    The correct answer is D.

    Explanation:

    Giving the following information:

    i = 0.1025

    NPV = - Io + ∑[Cf / (1+i) ^n]

    Cf = cash flow

    Project 1:

    Year 0 1 2 3 4 CFS:

    -$950 $500 $800 $0 $0

    Year 1 = 500 - 950 = - 450

    Year 2 = 800 - 450 = 350

    Payback period = 1 year + (450/800) = 1.56 years

    NPV=161.68

    Project 2:

    Year 0 1 2 3 4 5:

    -$2,100 $400 $800 $800 $1,000

    Year 1 = 400 - 2,100 = - 1,700

    Year 2 = 800 - 1,700 = - 900

    Year 3 = 800 - 900 = - 100

    Year 4 = 1000 - 100 = 900

    Payback period = 3 years + (100/1000) = 3.1 years

    NPV = 194.79

    Value lost = 194.79 - 161.68 = $33.11
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