Question

The software application development company for which you work is evaluating two different options for starting a new application development within the upcoming year. The company seeks to earn a return on each project that exceeds its cost of capital of 6.5 %. Further, the company assumes that given the current economic conditions, inflation may be expected to grow by 1% for the next year. Assume that the project takes place in Year 0 and begins earning cash flows on its application product from years 1 through 5.

Project Cash Flows

	Year 0	Y1	Y2	Y3	Y4	Y5
Project A	(-$50,000.00)	$5,000.00	$10,000.00	$20,000.00	$30,000.00	$65,000.00
Project B	(-$65,000.00)	$15,000.00	$20,000.00	$40,000.00	$45,000.00	$25,000.00

Answer the following questions based on the analysis of the given cash flows for Project A versus Project B:

What is the NPV for each proposed project?

Which project would you select based on the NPV?

Alter the discount rate based on the method presented in the videos in the Financial Analysis Tools section below so that you reach an NPV of "0" (or close to "0") thereby arriving at the project IRR. Which IRR is higher?

If inflation were not a factor, would your results change?

Answer 1

Cost of capital =6.5% or 0.065
Discount rates after adjusting for inflation = ( 1+ cost of capital)* ( 1+ Inflation) - 1 = (1.065)*(1+1%) -1 =0.07565 or 7.565%
a) Based on calculations in below table NPV of A = $54,923.12 and NPV of B = $56,907.97

So NPV of B is higher & Project B should be selected
c)for IRR calculation
NPV =0 = Cash Flow_t /(1+IRR)^t (where t is time )
IRR of A = 29.03%, IRR of B = 29.32%
Hence IRR of B is greater
d) Yes if inflation is not afactor results would change as given in table 2

Inflation adjusted cash flow(table-1)					Inflation adjusted discount rate			7.57%
	Year 0	Y1	Y2	Y3	Y4	Y5	NPV	IRR
Project A	($50,000.00)	$5,050.00	$10,201.00	$20,606.02	$31,218.12	$68,315.65	$54,923.12	29.03%
Project B	($65,000.00)	$15,150.00	$20,402.00	$41,212.04	$46,827.18	$26,275.25	$56,907.97	29.32%
NPV and IRR calculated using excel functions
Inflation adjusted cash flows = Cash at year 1* (1+inflation)^1
Inflation adjusted cash flows for year t = Cash at year t* (1+inflation)^t inflation 1% Discount rate 6.500% TABLE-2 Year 0 1 2 3 4 5 NPV IRR Project A ($50,000.00) $5,000.00 $10,000.00 $20,000.00 $30,000.00 $65,000.00 $50,830.36 27.77% Project B ($65,000.00) $15,000.00 $20,000.00 $40,000.00 $45,000.00 $25,000.00 $53,058.22 28.06% Best of luck. God Bless