Question

A company is contemplating investing in a new piece of manufacturing machinery. The amount to be invested is $210,000. The present value of the future cash flows is $225,000. The company’s desired rate of return used in the present value calculations was 12%. Which of the following statements is true? Select one: a. The project should not be accepted because the net present value is negative. b. The internal rate of return on the project is less than 12%. c. The internal rate of return on the project is more than 12%. d. The internal rate of return on the project is equal to 12%.

Answer 1

As the company has contemplating to invest in new machine , so first of all we have to calculate the NPV of the project.

NPV of the project = Present Value of Future Cash Flows - Initial Investment = $ 225000 - $210000 = $ 15000 i.e positive

Hence the project is viable, point a i.e NPV negative is false

INTERNAL RATE OF RETURN is interest rate on which our NPV becomes zero, i.e PV of Cash flows = Initial Investment, but in question it is positive , so point d is also false

If we increase interest rate, than present value of cash flows will decrease, i.e if interest rate is increased to more than 12% present value of cash value will decrease.

Hence @12% discount rate NPV is positive, but to make it zero (becuase of IRR) we have to increase the rate of Interest. so point B is also false and point C is true, which says IRR is more than 12%