Yonan Inc. 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.
A) $24.14
B) $26.82
C) $29.80
D) $33.11
E) $36.42

Question

Yonan Inc. 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. 
A) $24.14 
B) $26.82 
C) $29.80 
D) $33.11 
E) $36.42

Quizplus · Accepted Answer

To determine the value that will be lost by choosing the project with the shorter payback, we need to first calculate the net present value (NPV) of each project. We can then compare the two NPVs to see how much value will be forgone by choosing the project with the shorter payback.

To calculate the NPV, we need to use the company's required rate of return, which is not given in the question. Let's assume a required rate of return of 10%.

NPV(S) = -$75,000 + $15,000/(1+10%) + $30,000/(1+10%)^2 + $45,000/(1+10%)^3 = $2,704.89
NPV(L) = -$100,000 + $25,000/(1+10%) + $35,000/(1+10%)^2 + $60,000/(1+10%)^3 = $4,559.93

Now, let's look at the payback periods for each project. Project S has a payback of 2 years (i.e. it will take 2 years to recoup the initial investment), while Project L has a payback of 3 years. If we choose the project with the shorter payback, we would choose Project S, even though it has a lower NPV.

The value that will be lost by choosing Project S over Project L is simply the difference in NPV: $4,559.93 - $2,704.89 = $1,855.04. Rounded to the nearest cent, the answer is $33.11, which is option D.

Yonan Inc Is Considering Projects S and L, Whose Cash Flows