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The net present value (NPV) and internal rate of return (IRR) methods of investment analysis are interrelated and are sometimes used together to make capital budgeting decisions. Consider the case of Blue Hamster Manufacturing Inc.: Last Tuesday, Blue Hamster Manufacturing Inc. lost a portion of its planning and financial data when both its main and its backup servers crashed. The company's CFO remembers that the internal rate of return (IRR) of Project Lambda is 13.8%, but he can't recall how much Blue Hamster originally invested in the project nor the project's net present value (NPV). However, he found a note that detailed the annual net cash flows expected to be generated by Project Lambda. They are: Year Year 1 Year 2 Year 3 Year 4 Cash Flow $2,000,000 $3,750,000 $3,750,000 $3,750,000 The CFO has asked you to compute Project Lambda's initial investment using the information currently available to you. He has offered the following suggestions and observations: • A project's IRR represents the return the project would generate when its NPV is zero or the discounted value of its cash inflows equals the discounted value of its cash outflows-when the cash flows are discounted using the project's IRR. • The level of risk exhibited by Project Lambda is the same as that exhibited by the company's average project, which means that Project Lambda's net cash flows can be discounted using Blue Hamster's 9% WACC. , and its NPV is Given the data and hints, Project Lambda's initial investment is (rounded to the nearest whole dollar). A project's IRR will if the project's cash inflows decrease, and everything else is unaffected.

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projects (Autosaved) (Autosaved) (Autosaved) - Microsoft Excel (Product Activation Failed) Data Review View Add-Ins File Home Insert Page Layout Formulas - 2x % Cut Σ AutoSum : A pt General 3 AutoSum" 27 Wrap Text Merge Merge & Center - Center A U SF $ 4:0 .00 :.: Insert Delete Format % % , Number Cell Styles Calibri E Copy Paste Format Painter BI Clipboard NR226 NH NI Fill 2 Clear Conditional Format Formatting as Table Styles 11 AA = = = D- DA Font Fax N J NK Find & Select Sort & Filter Editing Alignment Cells NL NM NN NO NP NQ NR NS 219 220 PV FACTOR AT 13.8% 221 year CFAT IRR IS THE RATE WHERE NPV = 0 OR IN OTHER WORDS, INVESTMENT = PV OF CASHFLOWS SO INVESTMENT = 9433586 222 B 223 224 225 226 227 2000000 3750000 3750000 3750000 PV = 0.8787 0.7722 0.6785 0.5963 PV OF CFAT A*B 1757469.24 2895654.51 2544511.87 2235950.68 9433586 228 229 230 year ANSWERS INITIAL INVESTMENT NPV 9433586 1109859 231 232 1 0 1 2 233 234 235 236 PV FACTOR CFAT AT 9% B -9433586 2000000 0.9174 3750000 0.8417 3750000 0.7722 3750000 0.7084 NPV = PV OF CFAT A*B -9433586.31 1834862.39 3156299.97 2895688.05 2656594.54 1109859 A PROJECT'S IRR WILL DECREASE, IF PROJECT'S CASH FLOW DECREASES & EVERYTHING ELSE IS UNAFFECTED 4 237 238 239 invest, EAA MI-np-ir REPLACEMENT S HPR GMAM EAC MACRS NPV RELEVANT BETA LEVERED REPLACEMENT BOND I RRnpvbeta RATION PBP ARR ferences: E147 Rea OPTION TO WAIT STEIN II BOJ 120% - _ + . * 10 ENG 23-11-2019 2. B 19

projects (Autosaved) (Autosaved) (Autosaved) - Microsoft Excel (Product Activation Failed) Data Review View Add-Ins File Home Insert Page Layout Formulas - 2x % Cut pt General Wrap Text Merge Merge & Center - Center Σ AutoSum : A Fill 2 Sort & SF $ % % , 4:0 .00 :.: Insert Delete Format Conditional Format Formatting as Table Styles Cell Styles 2 Clear Calibri 11 AA = = = E Copy Paste Format Painter BI U D- DA Clipboard Font YL1 YCYDYE YE Find & Select Filter Editing Alignment Number Cells > YG YH YLYJYK YLYM YN YO YPYQ If the crossover rate on the NPV profile is below the horizontal axis, the methods will always agree õ ooo wa uewno y Z PROJECT YEAR CF 0 1 2 CF -1500 200 400 600 1000 -1500 900 600 300 10 11 12 200 13 14 15 16 > (=NPV(10%,$YE$9:$YE$12) +SYE$8] > [=NPV(10%,$YF$9:$YF$12) +$YF$8] NPV AT 10% IRR 340.54 293.36 13.49% 17.07% (=IRR(YF8:YF12)] (=IRR(YE8:YE12)] 17 YES THEY CONFLICT 18 19 W N invest, EAA MI-np-ir REPLACEMENT S HPR GMAM EAC MACRS NPV RELEVANT BETA LEVERED REPLACEMENT BOND IRRnpvbeta RATION PBP ARR ferences: KS336 OPTION TO WAITSTEIN id < BOU 130% 0 > Rea 2. B 19 . * 10 ENG 23-11-2019

- 2x Σ AutoSum : A Fill 2 TU projects (Autosaved) (Autosaved) (Autosaved) - Microsoft Excel (Product Activation Failed) File Home Insert Page Layout Formulas Data Review View Add-Ins % Cut Calibri 11 AA = = = pt Wrap Text General Ea Copy Paste B I Format Painter U B- A Merge & Center - $ -% Insert . Delete Format Formatting as Table Styles Clipboard Font Alignment Number Styles Cells YF76 for | EC YD YE YF YGYHYL YJ YK YL YM YN 2 Clear Sort & Filter Editing Find & Select YO YP Y Q 5 64 65 66 A key to resolving this conflict is the assumed reinvestment rate. The IRR Calculation assumes that intermediate cash flows are reinvested at the internal rate of return and the NPV calculation implicitly assumes that the rate at which cash flows can be reinvested is the required rate of return As a result, when evaluating mutually exclusive projects, the NPV method is usually the better decision 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 invest, EAA MI-np-ir REPLACEMENT S HPR GMAM EAC MACRS NPV RELEVANT BETA LEVERED REPLACEMENT I RRnpvbeta RATION PBP ARR ferences: NL296 Rea BOND OPTION TO WAITSTEIN II BOU 130% 0 19 . * 10 ENG 23-11-2019 2. B