Question

A company is considering two mutually exclusive expansion projects. Plan A requires a 21 million expenditure on a large scale integrated plant that would provide expected cash flows of $6.40 million per year for 6 years. Plan B requires a $7 million expenditure to build a somewhat less efficient, more labor-intensive plant with expected cash flows of $2.72 million per year for 6 years. The firm’s WACC is 10%. (Timeline required) a. Calculate each project’s NPV and IRR. b. Calculate the crossover rate where the two projects’ NPVs are equal c. Based on your answer to (b), explain when there will be a conflict between NPV and IRR in making capital budgeting decisions regarding mutually exclusive projects.

Answer 1

Solution:

Based on the two projects the time horizon of projects are same.Thus, by using normal NPV and IRR formula we can select which project to choose.

A) Calculation of NPV of projects:

CFn NPV= E - Initial Investment (1 + i)"

	Year	Amount (in Million's)	PV factor @9%	PV of Cashflows
PV of Cash Inflows	1	$6.40	0.92	$             5.87
	2	$6.40	0.84	$             5.39
	3	$6.40	0.77	$             4.94
	4	$6.40	0.71	$             4.53
	5	$6.40	0.65	$             4.16
	6	$6.40	0.60	$             3.82
		Total ==>		$           28.71
PV of Cash Outflows	0	($21)	1.00	($21)

NPV of Project A = PV of cash inflows - PV of Cash outflows  

= $28.71 - $21

= $7.71million

NPV of project B

	Year	Amount (in Million's)	PV factor @9%	PV of Cashflows
PV of Cash Inflows	1	$2.72	0.92	2.50
	2	$2.72	0.84	2.29
	3	$2.72	0.77	2.10
	4	$2.72	0.71	1.93
	5	$2.72	0.65	1.77
	6	$2.72	0.60	1.62
		Total ==>		$12.2
PV of Cash Outflows	0	($7)	1	($7)

NPV of Project A = PV of cash inflows - PV of Cash outflows  

= $12.2 - $7

= $5.2million