Question

Table 2: Cash flows B Borehole Landfill $300,000 Inflow year 1 $450,000 $300,000 Inflow year 2 $450,000 $300,000 Inflow year 3 $450,000 Inflow year 4 $450,000 $450, 000 Inflow year 5 -$1 500, 000 Inflow year 6 Question 3 [20 marks] Environ Ltd has revised its estimates of expected after-tax cash flows as shown in Table 2. The initial outlays are $800,000 for the landfill and $250, 000 for the borehole. Environ Ltd maintains the required rate of return at 12% for both projects. a. Based on the net present value (NPV) criterion, which project should Environ Ltd accept? Explain in detail, including all calculations. Also, clearly state all your assumptions. (10 marks) b. Based on the internal rate of return (IRR) criterion, which project should Environ Ltd accept? Explain in detail, with the graph of IRR and all working steps. Also, clearly state all your assumptions. (10 marks)

Answer 1

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Anwer (Question 3):

a.

For calculating the NPV of both Landfill and borehole project, we must account all the cash inflows and outflows

Landfill project:

=> Initial investment = -$250,000 - year 0

=> Cash inflows = $450,000 for years 1 to 5 = PV of these cash flows = 450000*(1-(1.12)^-5)/0.12 ( Using sum of G.P formula)

=> Cash inflow = -1,500,000 for 6th year = PV of these cash flows = -1,500,000/(1.12)⁶ = 470549

^=>  NPV of the Landfill project = sum of (-$800,000+ 450000*(1-(1.12)^-5)/0.12 + -1,500,000/(1.12)⁶ ) = 62202

Borehole project:

=> Initial investment = -$250,000 - year 0

=> Cash inflows = $300,000 for years 1 to 3 = PV of these cash flows = 300000*(1-(1.12)^-3)/0.12 ( Using sum of G.P formula)

=> NPV of the Borehole project = sum of (-$250,000+ 300000*(1-(1.12)^-3)/0.12) = 470549

From the above, calculations we find NPV of borehole project greater than Landfill project. So Borehole project should be accepted

b.

We know that IRR is the rate at which NPV of all the cashflows equals zero.

Landfill:

=> sum of (-$800,000+ 450000*(1-(1 + i)^-5)/i + -1,500,000/(1 + i)⁶ ) = 0 (From above statements)

=> Solving for i, we get i = 2.68%

Borehole:

=> sum of (-$250,000+ 300000*(1-(1+i)^-3)/i

=> Solving for i, we get i = 106%

So, with IRR rates also we find that Borehole project is feasible than the Landfill project.