Question

You are a financial analyst for the Waffle Company. The director of capital budgeting has asked you to analyze two proposed capital investments, Projects A and B. Each project has a cost of $50,000, and the cost of capital for each is 10%. The projects’ expected net cash flows are as follows: Expected Net Cash Flows Year

Project A Project B

0 ($50,000) ($50,000)

1 25,000 15,000

2 20,000 15,000

3 10,000 15,000

4 5,000 15,000

5 5,000 15,000

e. How might a change in the cost of capital produce a conflict between the NPV and IRR rankings of these two projects? Would this conflict exist if r were 6%? (Hint: Plot the NPV profiles.)

Answer 1

Net Present Value(NPV) is the difference between the present value of cash inflows and the present value of cash outflows. It is used in evaluating capital budgeting decisions. Projects with NPV greater than 0 are investable.

We are given,

Initial cost of both projects = $50,000

Cost of capiatl = 10%

We can calculate NPV for both projects using excel,

	Cashflows		Discounted cash flows
Yr	A	B	Discount factor @ 10%	A	B
0	-50000	-50000	1.000	-50000.0	-50000.0
1	25000	15000	0.909	22727.3	13636.4
2	20000	15000	0.826	16528.9	12396.7
3	10000	15000	0.751	7513.1	11269.7
4	5000	15000	0.683	3415.1	10245.2
5	5000	15000	0.621	3104.6	9313.8
			NPV	3289.0	6861.8
			IRR	13.57%	15.24%

NPV of project A = $3,289

NPV of project B = $6,6861.8

IRR of both projects is greater than the cost of capital(10%). With a 10% discount rate, NPV of Projejct B > NPV of Project A, hence we will select Project B.

Discount rate	NPV A	NPV B
0%	15000	25000
1%	13627	22801
2%	12304	20702
3%	11031	18696
4%	9803	16777
5%	8620	14942
6%	7478	13185
7%	6376	11503
8%	5311	9891
9%	4283	8345
10%	3289	6862
11%	2328	5438
12%	1398	4072
13%	498	2758
14%	-374	1496
15%	-1218	282
16%	-2036	-886
17%	-2830	-2010
18%	-3599	-3092
19%	-4346	-4135
20%	-5070	-5141

As we can see from the NPV profile of Project A & B, Project B's NPV is greater than Project A's NPV at all level of discount rate. It is below Project A NPV at a discount rate of 20%.

At a 6% discount rate, NPV of B > NPV of A.

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