12-6. Continued b. The answer in part a is misleading because the two investments seem to be equal with the same pay back period of three year Nevertheless, the Electric Co. is a superior investment because it recovers large cash flows in the first year, while the large recovery for Water Works is not until the third year. The problem is that the pay back method does not consider the time value of money 12-7 X-treme Vitamin Company is considering two investments, both of which cost $10.000. The cash flows are as follows eal Project A Project B $12,000 $10,000 800 6,000 6,000 16000 a. Which of the two projects should be chosen based on the payback method? b. Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 perce Should a firm normally have more confidence in answer a or answer b? Solution: X-treme Vitamin Company a. pay back Method Pay back for project A 10.000 = 83 years 12000 Payback for Project B 10,000 =l year 10,000 Under the pay back Method you should select Project a because of the shorter pay back period CopyrightC 2005 by The McGray-Hill Companies, Inc. S-428Copyright © 2005 by The McGraw-Hill Companies, Inc. S-428 12-6. Continued b. The answer in part a is misleading because the two investments seem to be equal with the same payback period of three year. Nevertheless, the Electric Co. is a superior investment because it recovers large cash flows in the first year, while the large recovery for Water Works is not until the third year. The problem is that the payback method does not consider the time value of money. 12-7. X-treme Vitamin Company is considering two investments, both of which cost $10,000. The cash flows are as follows: Year Project A Project B 1 $12,000 $10,000 2 8,000 6,000 3 6,000 16,000 a. Which of the two projects should be chosen based on the payback method? b. Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent. c. Should a firm normally have more confidence in answer a or answer b? Solution: X-treme Vitamin Company a. Payback Method Payback for Project A .83 years 12,000 10,000 = Payback for Project B 1 year 10,000 10,000 = Under the Payback Method, you should select Project A because of the shorter payback period