Question

Problem 7-13 NPV versus IRR Consider the following cash flows on two mutually exclusive projects for the Bahamas Recreation Corporation (BRC) Both projects require an annual return of 15 percent New Ride 950,000 Deepwater Submarine Fishing Year 0 -$975,000 $1,900,000 1 395,000 2 530,000 825,000 3 445,000 800,000 a-1. Compute the IRR for both projects. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places (e.g. 32.16)) IRR Deepwater Fishing Submarine Ride [ - ]% a-2. Based on the IRR, which project should you choose? Submarine Ride Deepwater Fishing b-1. Calculate the incremental IRR for the cash flows. (Do not round intermediate calculetions. Enter your answer as a percent rounded to 2 decimal places (e.g. 32.16).) Incremental IRR 7% b-2. Based on the incremental IRR, which project should you choose?

Answer 1

Requirement-(a-1) thru (b-2 Deepwater Submarine Incremetal CF Year (a-1) $975,000-$1,900,000 -$925,000 $395,000$950,000 $53 $555,000 30,000 $825, $445,000 18.70% ,000 $295,000 000 $355,000 16.01% 2 IRR 17.47% Task (a-2) (b-2) Decision Reason Deepwater IRR rule says, project with higher IRR shall be selected. Deepwater's IRR (18.70%) is higher than submarine's IRR(17.47%) Submarine IRR of Incremental Cash Flows is higher than cost of capital (15%) and so submarine shall be accepted Explanation: If Deepwater's cash flows are insert in cell numbers B2 to B5, Submarine's cash flows are insert in cell numbers C2 to C5 and incremental cash flows in D2 to D5 then IRR of each case in Cell number B6, C6 & D6 can be calculated using EXCEL FUNCTION IRR() with values as: IRR(B2:B5), IRR(C2:C5) & IRR(D2:D6) respectively as below:

Deepwater Submarine Incremetal CF Year 975000 39500O 53000O 1900000 950000 82500O C2-B2 -C3-B3 C4-B4 3 1 5 3 6 IRR IRR(B2:B5) IRR(C2:C5) IRR(D2:D5 Requirement-(c-1) & (c-2 Deepwater Submarine Discounted Cash Flows Discounted Cash Flows 1) x (3 Discount Factor @ 15% (1) 1.00000 0.86957 0.75614 0.65752 Cash Flows Cash Flows ear -$1,900,000 $1,900,000.00 0 1 2 $975,000 -$975,000.00 395,000 $343,478.26 $530,000 $400,756.14 $A45,000 $292,594.72 $61,829.13 $950,000 $825,000 $800,000 NPV $826,086.96 $623,818.53 $526,012.99 $75,918.47 NPV

When two projects are mutually exclusive, Submarine shall be selected because Submarine yields more positive NPV than Deepwater. Actually, NPV rule says that a project with positive NPV shall be selected. However, when two mutually exclusive projects with positive NPVs are evaluated, the project with higher NPV shall be preferred as it implies that the project with higher positive NPV will be capable of recovering all cash outflows before expiry of life of the project itelf but before the other project being taken up for evaluation. Requirement-(c-3 Yes, because based on IRR, Deepwater shall be accepted whereas based on NPV, Submarine shall be accepted.