Question

The Radford Company is faced with two mutually exclusive investment projects. Each costs $10,000 and each has an expected life of three years. Annual net cash flows from each project begin one year after the initial investment is made and have the following probability distribution.

Project A: Probability .3 .5 .2 Cash Flows 5,000 6,000 7,000

Project B: Probability .25 .6 .15 Cash Flows 2,000 5,000 8,000

The Radford company evalutes project A at 10% and project B at 12%

A. Compute the expected annual cash flow.

Project A ___ Project B___

B. What are the expected NPV and IRR of each project

Project A: NPV___ IRR____    Project B: NPV_____ IRR____

Answer 1

Answer A.

Answer B.

Project A:

Initial Investment = $10,000
Expected Annual Cash Flows = $5,900
Life of Project = 3 years
Discount Rate = 10%

NPV = -$10,000 + $5,900 * PVIFA(10%, 3)
NPV = -$10,000 + $5,900 * (1 - (1/1.10)^3) / 0.10
NPV = $4,672

Let IRR be i%

NPV = -$10,000 + $5,900 * PVIFA(i%, 3)
0 = -$10,000 + $5,900 * PVIFA(i%, 3)
PVIFA(i%, 3) = 1.6949

Using financial calculator, i = 35%

So, IRR of Project A is 35%

Project B:

Initial Investment = $10,000
Expected Annual Cash Flows = $4,700
Life of Project = 3 years
Discount Rate = 12%

NPV = -$10,000 + $4,700 * PVIFA(12%, 3)
NPV = -$10,000 + $4,700 * (1 - (1/1.12)^3) / 0.12
NPV = $1,289

Let IRR be i%

NPV = -$10,000 + $4,700 * PVIFA(i%, 3)
0 = -$10,000 + $4,700 * PVIFA(i%, 3)
PVIFA(i%, 3) = 2.1277

Using financial calculator, i = 19%

So, IRR of Project B is 19%