Question

Project 1 Project 2 Year o Year 1 Year 2 Year 3 IRR -10000 3500 3500 4500 7.0% -10000 1000 2000 8500 5.4% Project 3 -10000 9000 1500 1000 11.5% Project 4 -10000 2000 8500 1000 7.6% Project 5 -10000 11000 0 0 10.0% Q5: Based on independent research, why is IRR preferred to NPV? Cite your source. Type answer here. Q6: How does IRR help managers determine where to spend capital? Type answer here. Q7: Based on the project data IRR above, which project should you fund first? Why? Type answer here. Q8: If you have $30,000 to invest, which projects should NOT be selected? Why? Type answer here. Q9: Projects 2, 3, and 4 have the same values. Why does project 3 have higher IRR? Type answer here. Q10: Project 5 has the least amount of money recovered. Should you fund the project? Why or why not? Type answer here.

Answer 1

Q5)

For any Project / Major CAPEX evaluations, the three most common approaches are Payback period, Internal rate of return (IRR) and Net Present Value (NPV).

The payback period determines how long it would take a company to see enough in cash flows to recover the original investment.

The internal rate of return (IRR) calculates the percentage rate of return at which those same cash flows will result in a net present value of zero. It used to determine the attractiveness of the Project on the given amount of the value of the investment.

The Net Present Value (NPV) results in the total net cash inflows expected from a project at the present value using a discounting factor. This is used to quantify the results in value terms from the entire project, covering all the cashflows from the project.

While most of the times NPV and IRR result in the same outcome on the feasibililty of the Project, there shall be cases of conflicting opinions as well;

Incase of analysis of a single conventional project, both NPV and IRR might provide same indicator on the evaluation of the project or not. However, while comparing two projects, the NPV and IRR may provide conflicting results.

Also, incase of mutiple cash flows trends (positive, negative, positive, negative etc) during the Project period, the IRR fails to provide answer and in this case NPV shall be useful as it covers all the cashflows - either Positive or Negative.

However, incase of projects with different investment during their year 0, the IRR provides the better options to choose among the projects based on the threshold limit of the investment budget available.

Q6) Incase of the the projects with equal investment value and lives, the IRR with higher value shall be ranked as priority for invesment with decreasing priority along with the next higher IRR values, in the choice of options.

Q7) Based on the given projects IRR, the IRR of Project 3 is higher and the same need to be funded first.

Q8) Project 2 and Project 1 are with the lower IRRs among the given five projects; Hence, if there is a capital budget limit of $ 30000, then Project 2 and Project 1 should NOT be selected;

Q9) Althought the Projects 2, 3 and 4 have same values, the timing of cash flows determine the value of the IRR; Incase of Project 3, the amount of $ 9000 (higher cash flow amount all the three years) received in the Year 1 only, resulting in the higher IRR. Time value of money is considered.

Q 10) Although the Project 5 is recovering the least amount of cash flows as compared to rest of the projects the timing of receipt of cash flow ($ 11000 during Year 1 itself) is very important factor. No other project is having such higher cash flow during Year 1 and if you can obseve, this timing of receipt of cashflow has resulted in higher IRR of 10% and this is much higher than other Projects 1,2 & 4. Hence, this project can be funded as a next priority to Project 3.