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The Ford Motor Company is considering three mutually exclusive electronic stability control systems for protection against rollover of its automobiles. The investment period is four years​ (equal lives) and the MARR is 12% per year. Data for fixturing costs of the system are given below.

Alternative A
IRR = 19.2&
CAPITAL INVESTMENT = $12,000
NET ANNUAL RECEIPT = $4,000
SALVAGE VALUE = $3,000

Alternative B
IRR = 18
CAPITAL INVESTMENT = $15,800
NET ANNUAL RECEIPT = $5.200
SALVAGE VALUE = $3,500

Alternative C
IRR = 19.2&
CAPITAL INVESTMENT = $8,000
NET ANNUAL RECEIPT = $3.000
SALVAGE VALUE = $1,500

Required:
Which alternative is best and why?

Answer :

jepessoa

Answer:

Alternative C

Explanation:

                                   project A             project B             project C

initial investment        -12,000               -15,800                -8,000

NCF year 1                   4,000                 5,200                  3,000

NCF year 2                  4,000                 5,200                  3,000

NCF year 3                  4,000                 5,200                  3,000

NCF year 4                  7,000                 8,700                  4,500

NPV                             2,055.95   2,218.53      2,065.33

IRR                               19.2%                   18%                     19.2%

Payback period           3 years                3.04 years         2.67 years

Since all projects have a positive NPV and all NPVs have a very similar value, then we must use the projects' IRR to determine which project will be selected. We should select the project with the highest IRR.

But that leaves us with two options, project A and C, and we eliminate project B. Now we can use a third parameter which is payback period, since a shorter payback period reduces risk, it both projects have positive NPV's and high IRRs, then we should choose the project with the shortest payback period.

Project C's payback period is shortest, therefore, we should select that project.

The alternative that would be the most effective and its reason would be as follows:

- Alternative C because it offers the maximum IRR in a briefer payback period.

The IRR's and the payback period for the three alternatives are as follows:

           Alternative A            Alternative B                        Alternative C

IRR          19.2%                              18%                                     19.2%

Payback   3 years                            3.04 years                          2.67 years

  • In order to determine the best alternative, the one with the highest IRR would be most effective.
  • Here, two alternatives have similar IRRs and therefore, the payback period would be considered.
  • Therefore, the one with the highest IRR and lowest payback period would be the best alternative.

Thus, Alternative C is the correct answer.

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