Question

Dwight Donovan, the president of Fanning Enterprises, is considering two investment opportunities. Because of limited resources, he will be able to invest in only one of them. Project A is to purchase a machine that will enable factory automation, the machine is expected to have a useful life of three years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $110,000 and for Project B are $30,000. The annual expected cash inflows are $52,220 for Project A and $12,922 for Project B. Both investments are expected to provide cash flow benefits for the next three years. Fanning Enterprises' cost of capital is 8 percent. (PV of $1 and PVA of $1 (Use appropriate factor(s) from the tables provided.) Required a. Compute the net present value of each project. Which project should be adopted based on the net present value approach? b. Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach? Complete this question by entering your answers in the tabs below. Required A Required B Compute the net present value of each project. Which project should be adopted based on the net present value approach? (Round your intermediate calculations and final answers to 2 decimal places.) Net Present Value Project A Project B Which project should be adopted? Required A Required B > Required A Required B Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach? Internal Rate of Return Project A Project B Which project should be adopted? < Required A Required B >

Answer 1

Answer a)

Calculation of Net Present Value

Net Present Value: It the excess present value of cash inflows over the present value of cash outflows of a project discounted at cost of capital of an entity. Higher the Net present value better is the project.

Net Present Value = Present value of cash inflows – Present value of cash outflows

Project A

Net Present Value = Present value of cash inflows – Present value of cash outflows

                                  = $ 134,576 - $ $ 110,000

                                  = $ 24,576

Thus the Net Present value of Project A is $ 24,576

Working Notes:                         

Present Value of cash outflows: Since the cash outflow of $ 110,000 for purchase of equipment will be made today, its Present value factor will be “1” and thus the present value of cash outflows will be:

Present Value of Cash Outflows = Cash outflow X Present Value factor

                                                          = $ 110,000 X 1

                                                          = $ 110,000   

Therefore the present value of cash outflow for project A will be $ 110,000.

Present Value of Cash outflows:

Year End	Cash Inflows	Present Value Factor @ 8%	Present Value
1	$ 52,220	0.92593	$ 48,351.85
2	$ 52,220	0.85734	$ 44,770.23
3	$ 52,220	0.79383	$ 41,453.92
Total			$ 1,34,576.00

Therefore the present value of cash Inflow for project A will be $ 134,576.

Project B

Net Present Value = Present value of cash inflows – Present value of cash outflows

                                  = $ 33,301.25 - $ $ 30,000

                                  = $ 3,301.25

Thus the Net Present value of Project B is $ 3,301.25

Working Notes:                         

Present Value of cash outflows: Since the cash outflow of $ 30,000 for training of employees will be made today, its Present value factor will be “1” and thus the present value of cash outflows will be:

Present Value of Cash Outflows = Cash outflow X Present Value factor

                                                          = $ 30,000 X 1

                                                          = $ 30,000   

Therefore the present value of cash outflow for project B will be $ 30,000.

Present Value of Cash outflows:

Year End	Cash Inflows	Present Value Factor @ 8%	Present Value
1	$ 12,922	0.92593	$ 11,964.81
2	$ 12,922	0.85734	$ 11,078.53
3	$ 12,922	0.79383	$ 10,257.90
Total			$ 33,301.25

Therefore the present value of cash Inflow for project A will be $ 33,301.25

Decision: Since Net Present value of Project A (i.e. $ 24,576.00) is more than that of Project B (i.e. $ 3,301.25), Project A should be adopted based on NPV approach.

Answer b)

Calculation of Internal Rate of Return

Internal rate of return: It is the rate of return of a project at which the present value of its cash inflows become equal to present value of cash outflows. An internal rate of return greater than or equal to the cost of capital of a project is a viable project. Higher the internal rate of return, the better is its profitability.

  Project A

As Calculated in Part (a), the present value of cash outflows from Project A is $ 110,000.

Present value of cash inflows at 19% discounting factor:

Year End	Cash Inflows	Present Value Factor @ 19%	Present Value
1	$ 52,220	0.84034	$ 43,882.35
2	$ 52,220	0.70616	$ 36,875.93
3	$ 52,220	0.59342	$ 30,988.17
Total			$ 111,746.45

Present value of cash inflows at 20% discounting factor:

Year End	Cash Inflows	Present Value Factor @ 20%	Present Value
1	$ 52,220	0.83333	$ 43,516.67
2	$ 52,220	0.69444	$ 36,263.89
3	$ 52,220	0.57870	$ 30,219.91
Total			$ 110,000.46

From the perusal of above two tables, it is evident that the present value of cash outflows (i.e. $ 110,000) of Project A becomes approximately equal to the present value of its cash Inflows (i.e. $ 110,000.46) at 20% discounting factor. Thus the approximately internal rate if return of project A is 20%.

  Project B

As Calculated in Part (a), the present value of cash outflows from Project B is $ 30,000.

Present value of cash inflows at 14% discounting factor:

Year End	Cash Inflows	Present Value Factor @ 14%	Present Value
1	$ 12,922	0.87719	$ 11,335.09
2	$ 12,922	0.76947	$ 9,943.06
3	$ 12,922	0.67497	$ 8,721.98
Total			$ 30,000.13

Present value of cash inflows at 15% discounting factor:

Year End	Cash Inflows	Present Value Factor @ 15%	Present Value
1	$ 12,922	0.86957	$ 11,236.52
2	$ 12,922	0.75614	$ 9,770.89
3	$ 12,922	0.65752	$ 8,496.42
Total			$ 29,503.83

From the perusal of above two tables, it is evident that the present value of cash outflows (i.e. $ 30,000) of Project B becomes approximately equal to the present value of its cash Inflows (i.e. $ 30,000.13) at 14% discounting factor. Thus the approximately internal rate if return of project B is 14%

Decision: Since Internal rate of return of Project A (i.e. 20%) is more than that of Project B (i.e. 14%), Project A should be adopted based on internal rate of return approach.