In: Finance
You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $ 9.6 million. Investment A will generate $ 2.06 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $ 1.48 million at the end of the first year, and its revenues will grow at 2.2 % per year for every year after that. a. Which investment has the higher IRR? b. Which investment has the higher NPV when the cost of capital is 5.8 %? c. In this case, when does picking the higher IRR give the correct answer as to which investment is the best opportunity?
a]
IRR of Investment A = rate of return on investment = perpetual cash flow / initial investment = $2.06 million / $9.6 million = 0.2146, or 21.46%
IRR of Investment B = (first year cash flow / initial investment) + perpetual growth rate = ($1.48 million / $9.6 million) + 0.022 = 0.1762, or 17.62%
b]
NPV of Investment A = present value of cash inflows - initial investment
present value of cash inflows = perpetual cash flow / cost of capital = $2.06 million / 0.058 = $35,517,241
NPV of Investment A = $35,517,241 - $9,600,000 = $25,917,241
NPV of Investment B = present value of cash inflows - initial investment
present value of cash inflows = perpetual cash flow / (cost of capital - perpetual growth rate) = $1.48 million / (0.058 - 0.022) = $41,111,111
NPV of Investment A = $41,111,111 - $9,600,000 = $31,511,111
c]
Picking the higher IRR would give the correct answer when both investments have a constant perpetual cash flow, or both have a perpetual growth rate in cash flows. In this case, one of them has a constant perpetual cash flow, whereas another has a perpetual growth rate in cash flows. Hence, the IRR would not give the best answer