Question

5. You are deciding between two mutually exclusive investment projects. Both require the same upfront investment of $9.8 million. Investment A will generate $2 million per year in perpetuity (starting from the end of the first year) and Investment B will generate $1.45 million per year at the end of first year and, after the first year, its revenue will grow at 2.6% per year in perpetuity. The discount rate is 7.8%.

a) Which project has a higher IRR? [7.5 marks]

b) Which project would you choose to invest? Why? [7.5 marks]

5. You are deciding between two mutually exclusive investment projects. Both require the same upfront investment of S9.8 million. Investment A will generate S2 million per year in perpetuity (starting from the end of the first year) and Investment B will generate $1.45 million per year at the end of first year and, after the first year, its revenue will grow at 2.6% per year in perpetuity. The discount rate is 7.8%. a) Which project has a higher IRR? [7.5 marks] b) Which project would you choose to invest? Why? [7.5 marks]

Answer 1

NPV of project A = Initial cost + PV of cash flows

= -9.8+ 2/7.8%

=$15.84 million

IRR is that rate at which

9.8 = 2/IRR

IRR = 2/9.8= 20.41%

NPV of project B = Initial cost + PV of cash flows

= -9.8+ 1.45/(7.8%-2.6%)

=$18.08 million

IRR is that rate at which

9.8 = 1.45/ (IRR-0.026)

IRR- 0.026 = 1.45/9.8 = 0.147959

IRR = 0.147959+ 0.026

= 17.39%

A: Project A has a higher IRR.

B: Project B will be chosen since it has higher NPV and hence the value of the business increases.