Question

We have two independent and mutually exclusive projects, A and B. Project A requires an initial investment of $1000, and will yield $500 of cash inflows for the next three years. Project B requires an initial investment of $3,500, and will yield $1,000 of cash inflows for the next five years. The required return on both projects is 10%.

The NPV of Project A is 243.43

The NPV of Project B is 291.00

What is the problem with using the NPV investment criterion in this case? What alternative criterion should be used?

Which project should be chosen?

Answer 1

Project A
Discount rate	0.1
Year	0	1	2	3
Cash flow stream	-1000	500	500	500
Discounting factor	1	1.1	1.21	1.331
Discounted cash flows project	-1000	454.5455	413.2231	375.6574
NPV = Sum of discounted cash flows
NPV Project A =	243.43
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
Project B
Discount rate	0.1
Year	0	1	2	3	4	5
Cash flow stream	-3500	1000	1000	1000	1000	1000
Discounting factor	1	1.1	1.21	1.331	1.4641	1.61051
Discounted cash flows project	-3500	909.0909	826.4463	751.3148	683.01346	620.9213
NPV = Sum of discounted cash flows
NPV Project B =	290.79
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
Project A
IRR is the rate at which NPV =0
IRR	0.233751928
Year	0	1	2	3
Cash flow stream	-1000	500	500	500
Discounting factor	1	1.233752	1.522144	1.877948
Discounted cash flows project	-1000	405.2679	328.4841	266.2481
NPV = Sum of discounted cash flows
NPV Project A =	8.29303E-07
Where
Discounting factor =	(1 + IRR)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
IRR=	23.38%
Project B
IRR is the rate at which NPV =0
IRR	0.132015879
Year	0	1	2	3	4	5
Cash flow stream	-3500	1000	1000	1000	1000	1000
Discounting factor	1	1.132016	1.28146	1.450633	1.6421396	1.858928
Discounted cash flows project	-3500	883.3798	780.3599	689.3542	608.96162	537.9444
NPV = Sum of discounted cash flows
NPV Project B =	3.57483E-05
Where
Discounting factor =	(1 + IRR)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
IRR=	13.20%

Problem with NPV is that it doesnot take into consideration the size of the investment. To take care of this issue IRR method is used. Choose A as it has higher IRR