Capital Budgeting: Cost-Benefit Analysis

895 Words Jan 9th, 2018 4 Pages
The following chart provides precisely that comparison.1

Option A
Option B
Payback Period
7.48 years
4.0 years
IRR
8.07%
30.08%
NPV
($478,366)
$1,203,173

2. Based on the comparison of the two projects, it is recommended that Council accept Option B. Option B is the superior of the two projects on all three metrics. Option B has the faster payback period. When accounting for the time value of money, Option B has the higher internal rate of return, and the superior net present value.

When faced with two mutually exclusive projects, Council needs to undertake the project that is best financially. The payback period reflects the pace at which the project's cash flows are returned. As a decision-making tool, it is relatively weak because it takes into account neither the time value of money nor the cash flows that accrue after the payback period has ended. Option B has the shorter payback period and is therefore preferable.

IRR and NPV are related measures in that they are both based on the present value of future cash flows. That is, they both take into account the time value of money. Based on the capital cost, both of these projects are roughly the same size, and that should mean that the same project will be superior in both IRR and NPV. Using both tools is most effective when comparing projects of dramatically different sizes. In…
Open Document