Question

Project R delegates all the development work to outside companies. The estimated cashflows for Project R are (where brackets indicate expenditure):
Beginning of Year 1 (£150,000) (contractors’ fees)
Beginning of Year 2 (£250,000) (contractors’ fees)
Beginning of Year 3 (£250,000) (contractors’ fees)
End of Year 3 £1,000,000 (sales)
Project S carries out all the development work in-house by purchasing the necessary equipment and using the company’s own staff. The estimated cashflows for Project S are:
Beginning of Year 1 (£150,000) (New equipment)
Continuous payments Through Year 1 (£75,000) (Staff Cost)
Continuous payments Through Year 2 (£250,000) (Staff Cost)
Continuous payments Through Year 3 (£250,000) (Staff Cost)
End of Year 3 £1,000,000 (sales)
REQUIRED
a) Calculate the net present value for Project R and Project S using a risk discount rate of 20% per annum. Using net present values as a criterion, which project is preferable?
b) Find the internal rate of return for Project R and Project S and hence determine which project is more favourable using this criterion.

Answer 1

Project R

Beginning of Year 1 (£150,000) (contractors’ fees)
Beginning of Year 2 (£250,000) (contractors’ fees)
Beginning of Year 3 (£250,000) (contractors’ fees)
End of Year 3 £1,000,000 (sales)

Project S

Beginning of Year 1 (£150,000) (New equipment)
Continuous payments Through Year 1 (£75,000) (Staff Cost)
Continuous payments Through Year 2 (£250,000) (Staff Cost)
Continuous payments Through Year 3 (£250,000) (Staff Cost)
End of Year 3 £1,000,000 (sales)

discount rate of 20% per annum

Answer A.

Using Net Present value Project R is beneficial and prefered

Answer B.

Using IRR also Project R is Preferred

Formula used:

Project R

NPV of spend  NPV(B9,B4:B6)

NPV of sales NPV(B9,B7)

project S

NPV of spend NPV(D9,D4:D6)

NPV of sales NPV(D9,D7)

NPV of R =B2+B3

NPV of S =D2+D3