Question

Ibb Inc., a company with expertise in designing Internet-related computer software, is considering two possible capital investments. The first would require an initial investment of $1 million, but is forecast to repay $700,000 each year for two years. The second would require an initial investment of $2 million, but would repay $950,000 per year for three years. The appropriate discount rate (the required return) is 10% per year. Other than these two projects, your firm has no superior investment alternatives. Your goal is to maximize shareholder value. (a) Compute the NPV and the IRR for each project. If Ibbotson must choose between the two projects, which should it take? (b) The manager who provided the cash flow estimates for the first project argues that the company should invest shareholder capital to obtain the highest possible returns, and he asserts that this is project one. Does his argument alter your assessment of which project is better? Explain. (c) The first proposed project involves rice farming in Thailand. The manager who provided the cash flow forecasts is known to relish the idea of a two-year overseas assignment. The second proposed project involves development of software designed to search the Internet to obtain and compare prices for specified goods. Is this information relevant in choosing among the two projects?

Answer 1

I have used excel to calculate the NPV and IRR. Please see the snapshot below. The cells highlighted in yellow contains the answer. Adjacent cells highlighted in blue contain the excel formula used to get the answer.

Part (a)

71 Year 72 Discount Rate 73 Project 1 74 Cash flows 75 NPV 76 IRR 0 10% 1 (1,000,000) 700,000 700,000 214,876 NPV(G72,H74:174)+G74 RRIG74:174 25.69% 78 Project 2 79 Cash flows 80 NPV 81 IRR 82 (2,000,000)950,000 950,000 950,000 362,509 NPV(G72,H79:179)+G79 20.04%-IRR(G79:179

If one project has to be chosen, then the firm should choose the project with highest NPV. Hence, Project 2 should be chosen.

Part (b)

Project 1 has indeed higher IRR than project 1. However, when there is conflicting decision based on NPV and IRR, the firm should go ahead with decision based on NPV criteria and choose the project with highest NPV. And therefore the firm should project 2. Hence, the manager's argument will not alter my assessment.

Part (c)

Well, the information given are qualitative in nature. First project will have foreign currency exchange rate risk in addition to normal project risks. Hence, it's discount rate can be higher. Beside this, the information given will not have any impact on capital budgeting decision which are primarily based on financials.