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Problem 16-19 Using net present value and internal rate of return to evaluate investment opportunities LO 16-2, 16-3

Dwight Donovan, the president of Gibson 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 $101,000 and for Project B are $34,000. The annual expected cash inflows are $47,947 for Project A and $13,672 for Project B. Both investments are expected to provide cash flow benefits for the next three years. Gibson Enterprises’ cost of capital is 8 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Required

1. Compute the net present value of each project. Which project should be adopted based on the net present value approach?

2. Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach?

Answer 1

Project A Year Cash inflo Present Annuity factor@8% Present Value A*B -101000 -101000 47947 0.926 44395.37037 47947 41106.82442 47947 0.794 38061.87446 Net Present Value 22564 0.857 Project B Cash inflo Present Annuity factor@8% -34000 13672 13672 31 13672 Net Present Value 0.926 0.857 0.794 Present Value A*B -34000 12659.25926 11721.53635 10853.2744 1234 Conclusion: Project A Should be adopt as it gives more NPV

Project A Internal rate of return (i,e rate at which discounted cash inflows equal to cash outflows) Net Present value=0 Year Cash Flows ΙΑ 0 - 101000 IRR Fomula=IRR(B29:B32) 1 47947 47947 1,e IRR 20% 3 47947 Project B Internal rate of return (i,e rate at which discounted cash inflows equal to cash outflows) Net Present value=0 Year Cash Flows A 01 - 34000 IRR Fomula=IRR(B41:144) 13672 13672 1,e IRR 10% 3 13672 Conclusion: Project A Should be adopt as it has higher IRR