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Integrative Conflicting Rankings The High-Flying Growth Company (HFGC) has been growing very rapidly in recent years, making its shareholders rich in the process. The average annual rate of return on the stock in the last few years has been 24%, and HFGC managers believe that 24% is a reasonable figure for the firms cost of capital. To sustain a high growth rate, the HFGC CEO argues that the company must continue to invest in projects that offer the highest rate of return possible. Two projects are currently under review. The first is an expansion of the firms production capacity, and the second project involves introducing one of the firms existing products into a new market. Cash flows from each project appear in the following table: EEB a. Calculate the NPV for both projects. Rank the projects based on their NPVs b. Calculate the IRR for both projects. Rank the projects based on their IRRs c. Calculate the PI for both projects. Rank the projects based on their Pls d. The firm can only afford to undertake one of these investments. What do you think the firm should do?(Click on the icon located on the top-right corner of the data table below in order to copy its contents into a spreadsheet.) Year Plant expansion $3,400,000 $2,250,000 S2,500,000 $1,500,000 $2,500,000 Product introduction - $400,000 $325,000 $250,000 $275,000 $375,000 4

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Answer #1

Answer a , b and c:

碕 NPV RI Plant Expansion Product Introduction $1,884,591.53 1 $327,536.92 2 IRR RI Plant Expansion Product Introduction 53.31%) 65.13% 2 0 PI Plant Expansion Product Introduction 1.55 2 1.82 1

Workings:

Plant Expansion Year Cash flows PV NPV (cost of capital 24%) IRR Pl (PV/Initial Investment) 0 2 4 $3,400,000) $2,250,000 $2,500,000 $1,500,000 $2,500,000 $5,284,591.53 $1,884,591.53 53.31% 1.55 Product Introduction Year Cash flows PV NPV (cost of capital 24%) IRR Pl (PV/Initial Investment) 0 2 4 ($400, 000) $325,000 $250,000 $ 275,000$375,000 $727,536.92 $327,536.92 65.13% 1.82

Answer d:

There is huge difference in initial investment between the two projects. If value added to shareholders is the criteria, Project 'Plant Expansion' would have been recommended.

But the company is looking for highest rate of return, Project 'Product Introduction' is recommended since it has higher IRR and higher PI.

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