Question

You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $10.2 million. Investment A will generate $1.97 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $1.47 million at the end of the first year, and its revenues will grow at 2.7% per year for every year after that. a. Which investment has the higher IRR? b. Which investment has the higher NPV when the cost of capital is 5.6%? c. In this case, when does picking the higher IRR give the correct answer as to which investment is the best opportunity? a. Which investment has the higher IRR? The IRR of investment Ais 19.31%. (Round to two decimal places.) The IRR of investment Bis 17.11 %. (Round to two decimal places.) Based on the IRR, you would pick investment A . (Select from the drop-down menu.) b. Which investment has the higher NPV when the cost of capital is 5.6%? If the cost of capital is 5.6%, the NPV of investment Ais 5 million. (Round to two decimal places.) If the cost of capital is 5.6%, the NPV of investment B is $1 million (Round to two decimal places.) The NPV rule requires you to choose V. (Select from the drop-down menu.) c. In this case, when does picking the higher IRR give the correct answer as to which investment is the best opportunity? The best investment opportunity when picking the higher IRR occurs for all discount rates higher than % (Round to two decimal places.)

Answer 1

b) Let us assume a 5 year period for both projects to arrive at which project to be considered. Both projects have a negative NPV, A with -$1.81M and B with -$3.61. Project A has the highest NPV

Year	Porject A (A)	Porject B (B)	Discounting factor @5.6% (C)	Project A Discounted Cashflow (A)*(C)	Project B Discounted Cashflow (B)*(C)
0	$         (10.20)	$        (10.20)	1.000	$               (10.20)	$              (10.20)
1	$              1.97	$             1.47	0.947	$                    1.87	$                   1.39
2	$              1.97	$             1.51	0.897	$                    1.77	$                   1.35
3	$              1.97	$             1.55	0.849	$                    1.67	$                   1.32
4	$              1.97	$             1.59	0.804	$                    1.58	$                   1.28
5	$              1.97	$             1.64	0.762	$                    1.50	$                   1.25
			NPV	$                  (1.81)	$                (3.61)

NPV rule requires us to chose the project with the highest NPV.

c) In this case any investment which gives higher IRR is the best choice, because IRR is the break even point of discounted cashflows of a project, therefore any IRR which is more than breakeven cost of capital is better ot be chosen.