Question

Dwight Donovan, the president of Stuart 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 five 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 $104,000 and for Project B are $30,000. The annual expected cash inflows are $26,738 for Project A and $9,162 for Project B. Both investments are expected to provide cash flow benefits for the next five years. Stuart Enterprises’ cost of capital is 8 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

Project A:

Initial cash Outflow - $104,000

Annual Cash Inflow - $26,738

Cumulative Present value factor of $1 at 8% for 5 years = 3.99271

Present value of Cash Inflow for Project = $26,378 * 3.99271 = $105,319

Hence Net Present Value = $105,319 - $104,000 = $1,319

Project B:

Initial cash Outflow - $30,000

Annual Cash Inflow - $9,162

Cumulative Present value factor of $1 at 8% for 5 years = 3.99271

Present value of Cash Inflow for Project = $9,162 * 3.99271 = $36,581

Hence Net Present Value = $36,581 - $30,000 = $6,581

Based on NPV, Project B should be chosen since its NPV is higher.

For Internal rate of Return:

It should be noted that Project A at rate of 8% generates NPV of $1,319. We know that the project return for Project A is higher than 8% since NPV is positive.

Let's compute present value of Inflow at 9%:

Cumulative Present value factor of $1 at 9% for 5 years = 3.889651

Hence Present value of Cash Inflow: $26,738 * 3.889651 = $104,001

At 9% rate; Present value of Cash Inflow is equal to Initial Cash Outflow; Hence the internal rate of return for Project A is 9%.

Project B:

It should be noted that Project B at rate of 8% generates positive NPV of $6,581. We know that the project return for Project B is way more higher than 8% since NPV is negative.

Let's compute present value of Inflow at 15%:

Cumulative Present value factor of $1 at 15% for 5 years = 3.352155

Hence Present value of Cash Inflow: $9,162 * 3.352155 = $30,712.5

At 15% rate; Present value of Cash Inflow is near to Initial Cash Outflow; Hence the internal rate of return for Project B is above 15%.

Let's compute present value of Inflow at 16%:

Cumulative Present value factor of $1 at 16% for 5 years = 3.274294

Hence Present value of Cash Inflow: $9,162 * 3.274294 = $30,000

Hence the IRR is 16%.

Project B should be chosed based on IRR since the internal rate of return is higher than Project A.