Question

Question 2 20 Marks

JK Products is evaluating an investment in either of two competing projects that will allow the company to eliminate a production bottleneck and meet the growing demand for its products. The company’s engineering department narrowed the alternatives down to two –MD and HD. A project specialist developed the following estimates of cash flows for MD and HD over the relevant six-year time horizon. The company has an 11% required return and views these projects as equally risky.

Project MD Project HD
Initial Outflow (CF0) R670,000 R940,000
Year (t) Cash Inflows (CFt)
1 R250,000 170,000
2 200,000 180,000
3 170,000 200,000
4 150,000 250,000
5 130,000 300,000
6 130,000 550,000

Required:
2.1.Calculate the net present value (NPV) of each project, assess its acceptability and indicate which
project is best, using NPV.
2.2. Calculate the internal rate (IRR) of each project, assess its acceptability and indicate which
project is best, using IRR.
2.3.Calculate the profitability index (PI) of each project, assess its acceptability, and indicate which
project is best, using PI.
2.4.Draw the NPV profile project SQ and HT on the same set of axes and use this diagram to explain
why the NPV and the IRR show differences for these two mutually exclusive projects. Discuss
this difference in terms of both the “scale problem” and the “timing problem”.
2.5.Which of the two mutually exclusive projects would you recommend that JK Products undertake?
Why?

Answer 1

2.1. NPV

On calculator CF Mode

Project MD

CFo= - 670,000

C01= 250,000

F01= 1

C02= 200,000

F02= 1

C03= 170,000

F03= 1

C04= 150,000

F04= 1

C05= 130,000

F05= 2

NPV

I= 11

CPT NPV= 87,313.87

Project HD

CFo= - 940,000

C01= 170,000

F01= 1

C02= 180,000

F02= 1

C03= 200,000

F03= 1

C04= 250,000

F04= 1

C05= 300,000

F05= 1

C06= 550,000

F06= 1

NPV

I= 11

CPT NPV= 142,254.07

--> Based on NVP we can accept both the projects as both have positive NPV but the best will be Project HD because of higher NPV.

2.2. IRR

On calculator

For project MD

CF Mode, Fill in all the values till C05 as above;

IRR CPT

IRR= 15.17%

For project HD

CF Mode, Fill in all the values till C06 as above;

IRR CPT

IRR= 16.07%

-->Based on IRR we can accept both the projects as both have IRR greater than the required rate of return of 11% but the best will be Project HD because of higher IRR.

2.3.Profitability Index (PI)= (NPV+ Initial investment)/Initial investment

For project MD

PI= 87,313.87+670,000/670,000

= 1.13

For project HD

PI= (142,254.07+940,000)/940,000

=1.15

--> As PI increases, the project becomes more attractive.

Therefore both the projects should be selected as PI for both is above 1. But The best is the one with the higher PI i.e project HD.

2.4.

At Vertical intercept i.e at 0% NPV is undiscounted cash flow i.e 360,000 for MD or SQ and 710,000 for HD or HT

At Horizontal intercept it is the project's IRR, for MD/SQ 15.17% and HD/HT 16.07%; at IRR NPV is ZERO.

At 11% HD/HT is better than MD/SQ, but because the profiles cross somewhere beyond 11% and before the functions cross the required return axis the IRR of MD/SQ exceeds the IRR of HD/HT. This can be explained by the fact that HD's/HT’s larger scale causes its NPV to exceed that of MD/SQ. The smaller project and the timing of MD's/SQ’s cash flows – more in the early years – causes its IRR to exceed that of HD/HT, which has more of its cash flows in later years.

2.5. For mutually exclusive projects, the rule is to choose the project with the higher NPV. Therefore here we'll choose Project HD/HT over MD/SQ as HD/HT has higher NPV.