Question

Question 12 Consider the following two mutually exclusive projects: Year Cash Flow(A) -$300,000 20,000 50,000 50,000 390,000 Cash Flow(B) -$40,000 19,000 12,000 18,000 10,500 Whichever project you choose, if any, you require a 15 percent return on your investment. a) If you apply the NPV criterion, which investment will you choose? Why? b) If you apply the IRR criterion, which investment will you choose? Why? c) Based on your answers in (a) through (b), which project will you finally choose? Why?

Answer 1

A)

Cash Flow A Cash Flow B Year O (300,000.00) (40,000.00) 20,000.00 19,000.00 2 50,000.00 12,000.00 3 50,000.00 18,000.00 4 390,000.00 10,500.00 To calculate the NPV we use the financial calculator Required rate of return 15% NPV for A= 11058.065 NPV for B 3434,16 By using the NPV criteria we should choose Project A, project A has higher net present value and creates more value for shareholders

B)

Cash Flow A Cash Flow B Year 0 (300,000.00) (40,000.00) 20,000.00 1 19,000.00 50,000.00 2. 12,000.00 18,000.00 3 50,000.00 4 390,000.00 10,500.00 To calculate the IRR ( internal rate of return) we use the financial calculator Required rate of return 15% 16.20% IRR for A= IRR for B 19.50% If IRR is the sole criteria then you should probably choose, project B Project B has higher internal rate of return than project and also it exceeds the required rate of return of 15%

C)

Though the IRR of the project B is higher than project A and Also it is higher than the minimum required rate of return. IRR assumes that the cash flow being generated are being reinvested at the IRR which is not practical in the real world. NPV is more a realistic approach in the real where what value is added from every project after considering the cost of capital and time value of money is calculated. Since the NPV of project A is more than the NPV of project B , we should go ahead with project A.