Question

Problem 16-19 Using net present value and internal rate of return to evaluate investment opportunities LO 16-2, 16-3 Dwight Donovan, the president of Rundle Enterprises, is considering two investment opportunities. Because of limited resources, he will be able to invest in only one of them. Project A is to purchase a machine that will enable factory automation; the machine is expected to have a useful life of three years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $111.000 and for Project 8 are $35,000. The annual expected cash inflows are $43,851 for Project A and $14,572 for Project B. Both investments are expected to provide cash flow benefits for the next three years. Rundle Enterprises' cost of capital is 8 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.) Required a. Compute the net present value of each project. Which project should be adopted based on the net present value approach? b. Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach?

Answer 1

Requirement A:

Project A Project B Net present value $2,004.03 $2,552.04 Project B should be adopted

NPV is computed as:

For project A:

A B 1 2 Year 3 1 4 2 5 3 6 Total PV of cash inflows 7 Less: Cash outflows 8 Net present value Cash flows 43851 43851 43851 C Project A Pv factor @8% 0.9259 0.8573 0.7938 Present value of cash inflows =B3*C3 =B4*04 =B5*C5 =SUM(D3:05) 111000 =D6-D7

The above table will give following results

1 A B C Project A Year Cash flows Pv factor @8% Present value of cash inflows $43,851 0.9259 $40,601.64 2 $43,851 0.8573 $37,593.46 $43,851 0.7938 $34,808.92 6 Total PV of cash inflows $113,004.03 7 Less: Cash outflows $111,000 8 Net present value $2,004.03

For project B:

в 11 Year Cash flows 12 1 14572 13 2 14572 14 3 14572 15 Total PV of cash inflows 16 Less: Cash outflows 17 Net present value Project B Pv factor @8% 0.9259 0.8573 0.7938 Present value of cash inflows =B12*C12 =B13*C13 =B14*C14 =SUM(D12:014) 35000 =D15-D16

The above table gives the following results:

А BC Project B Year Cash flows Pv factor @8% Present value of cash inflows $14,572 0.9259 $13,492.21 $14,572 0.8573 $12,492.58 $14,572 0.7938 $11,567.25 15 Total PV of cash inflows $37,552.04 16 Less: Cash outflows $35,000 17 Net present value $2,552.04 2

As NPV of Project B is greater than Project A, thus Project B should be selected.

Requirement B

Internal rate of return 9% Project A Project B 12% Project B should be adopted

IRR can be computed as:

19 Year 200 21 1 22 2 23 3 24 Internal rate of return Project A |-111000 43851 43851 43851 =IRR(B20:B23) Project B |- 35000 14572 14572 14572 =IRR(C20:C23)

The above data will give the following results:

19 Year 21 22 BC Project A Project B ($111,000) ($35,000) $43,851 $14,572 $43,851 $14,572 $43,851 $14,572 9% 12% 24 Internal rate of return

As IRR of project B is greater than project A , thus project B should be selected.