Question

(3 marks) QUESTION 6 (6 marks) Consider the following two mutually exclusive projects: Year Cash Flow (A) Cash Flow (B) $20,000 10, 000 10, 000 10, 000 10, 000 - $315, 000 25, 000 250, 000 55, 000 400, 000 The required return is 15% for both projects. Required: a) Which project should be accepted based on the net present value (NPV) and profitability index (PI) capital budgeting techniques? (4 marks) b) Explain why mutually exclusive projects might give rise to conflicts between the NPV and IRR capital budgeting techniques, and how to resolve such conflicts. (2 marks)

Answer 1

A	B	C	D	E	F	G	H	I	J	K
2
3		a)
4		NPV is the present value of future cash flows less initial investment.
5		Profitability index is the ratio of the present value of future cash flows divided by initial investment.
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7		As per NPV criteria, projects with NPV higher than zero should be accepted.
8		As per PI criteria, project with PI higher than 1 should be accepted.
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10		In case of mutually exclusive projects only one project needs to be selected.
11		In this case acceptable project with highest NPV or PI should be selected.
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13		Required return	15%
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15		Year	Cash Flow (A)	Cash Flow (B)
16		0	($315,000)	($20,000)
17		1	$25,000	$10,000
18		2	$50,000	$10,000
19		3	$55,000	$10,000
20		4	$400,000	$10,000
21		NPV	$9,411.00	$8,549.78	=NPV($D$13,E17:E20)+E16
22		PI	1.03	1.43	=NPV($D$13,E17:E20)/(-E16)
23
24		As per NPV rule, both project can be selected as NPV is positive.
25		Since the projects are mutually exclusive, therefore project with higher NPV i.e. Project A should be accepted.
26
27		As per PI rule, both project can be selected as PI is higher than 1 for both the projects.
28		Since the projects are mutually exclusive, therefore project with higher PI i.e. Project B should be accepted.
29
30		b)
31
32		The mutually exclusive projects will give rise to conflict between the NPV and the IRR techniques,
33		when projects differs in intial investment or timing of cash flow.
34		In this cash NPV profile of the two projects intersects and if cross over rate is higher than required rate of return,
35		then the two techniques will result in conflicting result as NPV discount the cash flow at
36		cost of capital whereas IRR discount the cash flows IRR.
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38		Discounting the cash flows at cost of capital is more accurate,
39		therefore in such cases NPV technique should be accepted.
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