Question

A company is considering two mutually exclusive expansion plans. Plan A requires a $39 million expenditure on a large-scale integrated plant that would provide expected cash flows of $6.23 million per year for 20 years. Plan B requires a $12 million expenditure to build a somewhat less efficient, more labor-intensive plant with an expected cash flow of $2.69 million per year for 20 years. The firm's WACC is 9%.

a.) A company is considering two mutually exclusive expansion plans. Plan A requires a $39 million expenditure on a large-scale integrated plant that would provide expected cash flows of $6.23 million per year for 20 years. Plan B requires a $12 million expenditure to build a somewhat less efficient, more labor-intensive plant with an expected cash flow of $2.69 million per year for 20 years. The firm's WACC is 9%.

Plan A:

Plan B:

b.) By graphing the NPV profiles for Plan A and Plan B, determine the crossover rate. Round your answer to one decimal place.

c.) Calculate the crossover rate where the two projects' NPVs are equal. Round your answer to one decimal place.

d.) Is NPV better than IRR for making capital budgeting decisions that add to shareholder value?

Answer 1

The time horizon of both the projects is the same. Thus, by using normal NPV and IRR formula we can select which project to choose.

a)

The formula for NPV is

Now, we will use the excel formula to calculate the NPV

The cash flow and NPV of Project A and B is as follows

Thus

NPV of firm A = 16.40

NPV of firm B =11.52

b)

To draw NPV profile first we need to calculate NPV from above cash flows at various discount rates as follows

The NPV profile is as follows

c)

To calculate the crossover rate we need to calculate the difference in cash flows of both the projects and then calculate the IRR of those cash flows. This IRR is the crossover rate of both the cash flows

A-B
-27
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
3.54
11.67%

The IRR = 11.67%

Hence, the crossover rate is 11.67%

d)

NPV is always better than IRR in selecting mutually exclusive projects. One reason is that IRR assumes that the cash flow is reinvested at IRR. This is a problematic assumption because there is no guarantee that such opportunities will be available in future. Whereas, NPV assumes that the cash-flows will be reinvested at Cost of capital which is a realistic and practical assumption. Hence, NPV is better than IRR