Question

Dwight Donovan, the president of Finch 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 five 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 $120,000 and for Project B are $39,000. The annual expected cash inflows are $40,126 for Project A and $10,819 for Project B. Both investments are expected to provide cash flow benefits for the next five years. Finch Enterprises’ cost of capital is 6 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

a. Compute the net present value of each project. Which project should be adopted based on the net present value approach?

	Net Present Value
Project A	?
Project B	?
Which project should be adopted?	?

b. Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach?

	Internal Rate of Return
Project A	%
Project B	%
Which project should be adopted?

TABLE 1 PRESENT VALUE OF $1 4% 5% 6% 7% 8% 9% 10% 12% 14% 16% 20% h 0.952381 0.892857 1 0.961538 0.943396 0.934579 0.925926 0.917431 0.909091 0.877193 0.862069 0.833333 2 0.924556 0.907029 0.889996 0.873439 0.857339 0.841680 0.826446 O.797194 O.769468 O.743163 0.694444 0.751315 0.711780 0.640658 0.888996 0.863838 0.839619 0.816298 O.793832 0.772183 0.674972 0.578704 0.762895 0.854804 0.822702 O.792094 O.735030 O.708425 0.683013 0.635518 0.592080 0.552291 0.482253 0.747258 0.519369 0.712986 0.680583 0.401878 0.821927 0.783526 0.649931 0.620921 0.567427 0.476113 O.666342 0.630170 0.455587 0.334898 6 O.790315 0.746215 O.704961 0.596267 0.564474 0.506631 0.410442 0.583490 0.279082 7 O.759918 0.710681 0.665057 0.622750 0.547034 0.513158 0.452349 0.399637 0.353830 0.627412 0.582009 0.540269 0.232568 0.730690 0.676839 0.501866 0.466507 0.403883 0.350559 0.305025 0.644609 0.591898 0.460428 0.360610 9 O.702587 0.543934 0.500249 0.424098 0.307508 0.262953 0.193807 0.226684 10 0.675564 0.613913 0.558395 0.508349 0.463193 0.422411 0.385543 0.321973 0.269744 0.161506 0.195417 11 0.649581 0.584679 0.526788 0.475093 0.428883 0.387533 0.350494 0.287476 0.236617 0.134588 0.397114 12 0.624597 0.556837 0.496969 0.444012 0.355535 0.318631 0.256675 0.207559 0.168463 0.112157 0.600574 0.530321 0.229174 13 0.468839 0.414964 0.367698 0.326179 0.289664 0.182069 0.145227 0.093464 0.125195 0.442301 0.299246 14 0.577475 0.505068 0.387817 0.340461 0.263331 0.204620 0.159710 0.077887 15 0.555265 0.481017 0.417265 0.362446 0.315242 0.274538 0.239392 0.182696 0.140096 0.107927 0.064905 0.533908 0.393646 16 0.458112 0.338735 0.291890 0.251870 0.217629 0.163122 0.122892 0.093041 0.054088 0.371364 0.231073 0.145644 17 0.513373 0.436297 0.316574 0.270269 0.197845 0.107800 0.080207 O.045073 0.415521 18 0.493628 0.350344 0.295864 0.250249 0.211994 0.179859 0.130040 0.094561 0.069144 0.037561 0.082948 19 0.474642 0.395734 0.330513 0.276508 0.231712 0.194490 0.163508 0.116107 0.059607 0.031301 0.178431 0.103667 20 0.456387 0.376889 0.311805 0.258419 0.214548 0.148644 0.072762 0.051385 0.026084

Answer 1

		Project A	Project B
	Project Cost	$120,000	$39,000
	Project life	5 years	5 years
	Salvage value	$                                              -	$                                              -
	Annual cash inflows	$40,126	$10,819
(A) Calculation of Net present value
	Cash (Outflow)/Inflow			Discounted cash flow
Year	Project A	Project B	Discounting Factor @ 6%	Project A	Project B
0	$                                 (120,000)	$                                  (39,000)	1.000000	$                    (120,000.00)	$                       (39,000.00)
1	$                                      40,126	$                                     10,819	0.943396	$                         37,854.72	$                         10,206.60
2	$                                      40,126	$                                     10,819	0.889996	$                         35,712.00	$                           9,628.87
3	$                                      40,126	$                                     10,819	0.839619	$                         33,690.56	$                           9,083.84
4	$                                      40,126	$                                     10,819	0.792094	$                         31,783.55	$                           8,569.66
5	$                                      40,126	$                                     10,819	0.747258	$                         29,984.48	$                           8,084.59
			Net Present Value	$                         49,025.31	$                           6,573.56
			Net Present Value
	Project A		$                               49,025.31
	Project B		$                                 6,573.56
	Project to be adopted:	Project A, because Net present value is comparatively higher.
		High NPV means that the project will reap more benefits in terms of cash inflows to the
		firm net of discounting adjustments.
(B) Calculation of Internal Rate of Return
Project A:
Year	Cash (Outflow)/Inflow	Discounting factor @18%	Discounted cash flow	Discounting factor @21%	Discounted cash flow
0	$                                 (120,000)	1.000000	$                          (120,000.00)	1.000000	$                    (120,000.00)
1	$                                      40,126	0.847458	$                               34,005.08	0.826446	$                         33,161.98
2	$                                      40,126	0.718184	$                               28,817.87	0.683013	$                         27,406.60
3	$                                      40,126	0.608631	$                               24,421.92	0.564474	$                         22,650.08
4	$                                      40,126	0.515789	$                               20,696.54	0.466507	$                         18,719.08
5	$                                      40,126	0.437109	$                               17,539.44	0.385543	$                         15,470.31
		Total	$                                 5,480.86		$                         (2,591.95)
	IRR (Using Interpolation)	18+[5480.86/(5480.86+259.95)]*(21-18)
		20.036785%
Project B:
Year	Cash (Outflow)/Inflow	Discounting factor @10%	Discounted cash flow	Discounting factor @13%	Discounted cash flow
0	$                                    (39,000)	1.000000	$                            (39,000.00)	1.000000	$                       (39,000.00)
1	$                                      10,819	0.909091	$                                 9,835.45	0.884956	$                           9,574.34
2	$                                      10,819	0.826446	$                                 8,941.32	0.783147	$                           8,472.86
3	$                                      10,819	0.751315	$                                 8,128.47	0.693050	$                           7,498.11
4	$                                      10,819	0.683013	$                                 7,389.52	0.613319	$                           6,635.50
5	$                                      10,819	0.620921	$                                 6,717.75	0.542760	$                           5,872.12
		Total	$                                 2,012.52		$                             (947.07)
	IRR (Using Interpolation)	10+[2012.52/(2012.52+947.07)]*(13-10)
		12.04%
			Internal Rate of Return
	Project A		20.036785%
	Project B		12.04%
	Project to be adopted:	Project A, because Internal Rate of Return is comparatively higher.
		High NPV means that the project will get better return on the investment
		Higher IRR means high rate of cash inflows from project.