Question

. Simson and Simpson, Inc. with its WACC of 10% has two investment proposals with the following characteristics:

​____________________________________________________________________________

​​​PROJECT A​​​PROJECT B

​__________________________​​_________________________

​Period ICO Cash Flows ICO Cash Flows

​____________________________________________________________________________

​ 0​​ $(9,000)​ -​$(12,000)​ -

​ 1​​​$5,000​ $5,000

​ 2​​​$4,000​ $5,000

​ 3​​​$3,000​ ​ $8,000

____________________________________________________________________________

(A).​Compute the internal rate of return for Projects A & B. (5)

(B).​On a graph draw the net present value profiles for each project using 5 discount rates. (5)

(C).​Identify the crossover point. What is the significance of this point? Which project should be accepted, why? (5)

(D).​Explain the difference between incremental cost and opportunity cost. What are sunk costs and should we consider ​them when making capital budgeting decisions? Why

Answer 1

A) To calculate IRR we put Outflow= Inflow

So for project A we have 9000= (5000/(1+r))+(4000/(1+r)²)+(3000/(1+r)³)

Now by Trial & Error method we can find out the IRR

Like replace r with 15% we get inflow as 9344 but we want it to be near 9000 so again we put 17% we get 9168 we can put r = 18% we get 8935 so r is between 17 and 18 % so by interpolation also we can get otherwise by Trial and error if we do r is coming approx 17.5%

If we do Interpolation

x-17/18-17=(9000-9168)/(8935-9168) so we get 17.7 (approx)

Similarly for project B

Outflow = Inflow

12000=(5000/(1+r))+(5000/(1+r)²)+(8000/(1+r)³)

By trial and error we get

18% we get inflow 12697 but we want it to be equal to outflow so we keep trying by

20% we get 12268 try 21 we get 12063 approx

so we can take IRR at 21%

we can also do by interpolation as suggested earlier for Project A

2)Calculation of NPV at different discount rate(NPV=Present value of inflow -Outflow)

Discount rate	Project A	Project B		Year	Project A	Project B
10%	Rs. 1,105.18	Rs. 2,688.20		0	-9000	-12000
12%	Rs. 788.40	Rs. 2,144.50		1	5000	5000
13%	Rs. 636.52	Rs. 1,884.91		2	4000	5000
15%	Rs. 344.95	Rs. 1,388.67		3	3000	8000
18%	Rs. -64.08	Rs. 697.26

For graph we need to plot in x axis discount rate and y axis NPV

c)Crossover Point:Is the discount rate at which both the project will deliver same net present value.Crossover point helps managers help evaluate profit with respect to risk factors.

difference of outflow = Present value of difference of inflow

(12000-9000)=0/(1+r)+1000/(1+r)²+5000/(1+r)³

Again we have to use the method of IRR to calculate r.

at 21% its coming 3505

at 22.5% its coming 3386

at 24% its coming 3272

at 25% its coming 3200

at 27% its coming 3060

approx 27.2% by Trial and error

At this discount rate both project will present same NPV.

D)Incremental cost is the additional cost for an extra unit of output. Like we have to spend 5$ more to produce additional 1 output.

whereas Opportunity cost is the benefit we forgo when we put the same money in the other alternative like instead of spending we put the money in bank and get interest rate the interest which we have forgone is the opportunity cost.

Sunk cost are cost which have already taken place it plays no role in NPV thus these cost have already occurred and are irrelevant for capital budgeting purpose so we should not consider it .They are independent event and are not in particular to a project.Example: Last month Salary to staff this is not related to the project proposal its last month so should be ignored.