Question

Problem 16-19 Using net present value and internal rate of return to evaluate investment opportunities LO 16-2, 16-3

Dwight Donovan, the president of Vernon Enterprises, is considering two investment opportunities. Because of limited resources, he will be able to invest in only one of them. Project A is to purchase a machine that will enable factory automation; the machine is expected to have a useful life of four years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $112,000 and for Project B are $32,000. The annual expected cash inflows are $43,264 for Project A and $10,536 for Project B. Both investments are expected to provide cash flow benefits for the next four years. Vernon Enterprises’ cost of capital is 6 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Required

Compute the net present value of each project. Which project should be adopted based on the net present value approach?

Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach?

Answer 1

Ans1.)

Calculation of Net Present Value of both projects:

Project A
Particulars	Amount
Projected Cash inflows(a)	43264
Discounting Factor(b)	6%
No of years(c)	4
PV Annuity Factor(d)	3.465106
PV of Cash Inflows {e=(a*d)}	149914.3
Cash Outflow (f)	112000
NPV (e-f)	37914.33

Project B
Particulars	Amount
Projected Cash inflows(a)	10536
Discounting Factor(b)	6%
No of years(c)	4
PV Annuity Factor(d)	3.465106
PV of Cash Inflows {e=(a*d)}	36508.35
Cash Outflow (f)	32000
NPV (e-f)	4508.35

Conclusion: Since NPV in Project A is higher Project A should be choosen.

Ans 2)

Calculation Of Internal Rate of Return:

Irr can be calculated by a simple formula

Outflow = Inflow

In Project A :
112000 = 43264 PVAF (r, 4)

By following trail and error method:

Let us assume r = 18%

PV of Cash Inflows will be = 149914

Since PV of cash inflows are higher we have to discount it by higher r

Let us take r= 20%

PV of CAsh Inflows = 111,999.01234

So IRR for project A = 20%

In Project B :
32000 = 10536 PVAF (r, 4)

By following trail and error method:

Let us assume r = 15%

PV of Cash Inflows will be = 30080

Since PV of cash inflows are lower we have to discount it by lower r

Let us take r= 12%

PV of CAsh Inflows = 32001.5127

So IRR for project B = 12%

Conclusion: BAsed on IRR, Project A should be choosen because it has higher IRR.