Question

Question 1    Mr Tommy Tan is considering two potential investment projects that have similar capital requirements:

                              Year 0                   Year 1                   Year 2                   Year 3                   Year 4

Project A (4,000,000)        1,600,000        1,800,000        2,000,000        2,100,000       

Project B (4,200,000)        500,000           1,700,000        1,900,000        2,000,000

For Project A, the company cost of capital is assumed to be 14%. For Project B, assessed as the riskier project of the two, a risk-adjusted cost of capital of 15% is considered appropriate.

(b) Calculate the IRR of the two (2) projects and assess the projects using the investment appraisal technique of Internal Rate of Return.

(c) Is the company’s cost of capital suitable in the evaluation of projects with different risks? Explain your answer.

Answer 1

		PROJECT A
			Year	Cashflow
			0	(4,000,000)
			1	1,600,000
			2	1,800,000
			3	2,000,000
			4	2,100,000
		Internal Rate of Return	29%		(Using IRR function of excel over the cashflow)
		PROJECT A
			Year	Cashflow
			0	(4,200,000)
			1	500,000
			2	1,700,000
			3	1,900,000
			4	2,000,000
		Internal Rate of Return	14%		(Using IRR function of excel over the cashflow)
		Project A is accepted, IRR is higher than cost of capital
		Project B is rejected , IRR is less than risk adjusted cost of capital
	c	No, Company's cost of capital is not suitable in evaluation of projects with different risks
		Cost of capital is the minimum acceptable rate of return(MARR) from the existing project
		For projects with similar risks as existing project, cost of capital can be used
		But , for projects with different risks cost of capital needs to be adjusted for risks to determine MARR