Question

As director of capital budgeting, you are reviewing three potential investment projects with the following cost and cash flow projections.

Cash Flow	Project A	Project B	Project C
Investment Cost	($400,000)	($375,000)	($400,000)
Year One Cash Flow	$200,000	$75,000	$50,000
Year Two Cash Flow	$50,000	$75,000	$120,000
Year Three Cash Flow	$75,000	$85,000	$140,000
Year Four Cash Flow	$50,000	$225,000	$125,000
Year Five Cash Flow	$125,000	$60,000	$125,000

1.Calculate the Internal Rate of Return (IRR) for each project.

2.Assuming your capital investment budget of $500,000 will only allow selection of one project (thus the projects are now mutually exclusive), which project should you fund?

Answer 1

Correct Answer:

1.

	IRR
Project A	9%
Project B	16%
Project C	11%

2.

Which project should you fund ?

Project B, because it has the highest IRR of 16% in all the three projects.

Working:

Project A
year	Cash Inflow (outflow)	Discount rate @ 5%	Present value	Discount Rate @ 10 %	Present value
0	$     (400,000)	1	$ (400,000.00)	1	$        (400,000)
1	$        200,000	0.952381	$    190,476.19	0.909091	181,818.18
2	$          50,000	0.907029	$      45,351.47	0.826446	41,322.31
3	$          75,000	0.863838	$      64,787.82	0.751315	56,348.61
4	$          50,000	0.822702	$      41,135.12	0.683013	34,150.67
5	$        125,000	0.783526	$      97,940.77	0.620921	77,615.17
	Net Present Value 1			NPV 2
			$      39,691.38		$            (8,745)

IRR = R1 + ((NPV1/(NPV1-NPV2))*(R2-R1))
A	R1 =	0.05
B	R2 =	0.1
C	NPV 1	$            39,691.38
D	NPV2	$                  (8,745)
E	NPV1-NPV2 =	48,436.43
F	NPV1/(NPV1-NPV2)	0.81945294
G	R2-R1 =	0.05
H	F * G	0.040972647
(A+H)	Project a IRR =	9%

Project B
year	Cash Inflow (outflow)	Discount rate @ 15%	Present value	Discount Rate @ 20 %	Present value
0	$     (375,000)	1	$ (375,000.00)	1	$        (375,000)
1	$          75,000	0.869565	$      65,217.39	0.833333	62,500.00
2	$        120,000	0.756144	$      90,737.24	0.694444	83,333.33
3	$        140,000	0.657516	$      92,052.27	0.578704	81,018.52
4	$        125,000	0.571753	$      71,469.16	0.482253	60,281.64
5	$        125,000	0.497177	$      62,147.09	0.401878	50,234.70
	Net Present Value 1			NPV 2
			$        6,623.15		$          (37,632)

IRR = R1 + ((NPV1/(NPV1-NPV2))*(R2-R1))
A	R1 =	0.15
B	R2 =	0.20
C	NPV 1	$              6,623.15
D	NPV2	$               (37,632)
E	NPV1-NPV2 =	44,254.97
F	NPV1/(NPV1-NPV2)	0.149658941
G	R2-R1 =	0.05
H	F * G	0.007482947
A+H	Project B IRR =	16%

Project C
year	Cash Inflow (outflow)	Discount rate @ 8%	Present value	Discount Rate @ 14 %	Present value
0	$     (400,000)	1	$ (400,000.00)	1	$        (400,000)
1	$          50,000	0.925926	$      46,296.30	0.877193	43,859.65
2	$        120,000	0.857339	$    102,880.66	0.769468	92,336.10
3	$        140,000	0.793832	$    111,136.51	0.674972	94,496.01
4	$        125,000	0.73503	$      91,878.73	0.59208	74,010.03
5	$        125,000	0.680583	$      85,072.90	0.519369	64,921.08
	Net Present Value 1			NPV 2
			$      37,265.10		$          (30,377)

IRR = R1 + ((NPV1/(NPV1-NPV2))*(R2-R1))
A	R1 =	0.08
B	R2 =	0.14
C	NPV 1	$            37,265.10
D	NPV2	$               (30,377)
E	NPV1-NPV2 =	67,642.22
F	NPV1/(NPV1-NPV2)	0.550914817
G	R2-R1 =	0.06
H	F * G	0.033054889
A+H	Project C IRR =	11%

End of answer.

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