Question

Mainstream Inc. uses multiple methods to determine which project to select. When evaluating its latest project, the development of an electric engine, the results of the multiple methods were: • Net Present Value = a negative amount of $(12,458) • Internal Rate of Return = 12.86% (required return must be 11.4%) • Payback Period = 3.58 years (Payback Period must be less than 4 years)

Required: a) Should Mainstream Inc. accept or reject the project to develop the electric engine? b) Why?

Answer 1

As per the results available, Mainstream Inc. should consider the following decision:-

a) If Mainstream Inc. wants to follow NPV approach, then the company must reject the proposal as the project is showing NPV=a negative amount of $(12,458).  As the NPV rule states that if a project have a positive net present value then it should be accepted while if the project shows negative NPV then it should be rejected.

b) The project shows IRR> required rate of return, and Payback period 3.58 years (Payback Period must be less than 4 years, which is a good thing to proceed for a project. As the rule says that if the internal rate of return on a project or investment is greater than the minimum required rate of return, i.e. the cost of capital, then it would profitable to accept the project and short payback period is accepted as it states that the project would pay for itself within a smaller or same time frame.

In this case, Overall decision can be accept the project as the IRR> ke and Payback period is also short but if Mainstream Inc. specifically wants to go for NPV method, then it won't be a good idea to accept the project.