Question

Carlson Development owns a prime parcel of land that can be developed into a residential, commercial, or industrial complex. Carlson plans to manage each of the projects for seven years and then cash out. After considerable research, Carlson estimates that cash flows from the three alternative projects are as follows:

        Cash Flows In Millions

Project	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
Residential	(25.0)	2.0	2.0	2.0	2.0	2.0	2.0	52.0
Commercial	(26.6)	6.0	6.0	6.0	6.0	6.0	6.0	16.0
Industrial	(21.0)	4.0	4.0	4.0	4.0	4.0	4.0	14.0

Calculate the NPV and IRR on the three projects identify which (if any) project should Carlson select?

Answer 1

To calculate IRR use the formula

Cash flow at Year 0 = Sum(Cash flow at Year t/(1+IRR)^t)

In this problem we have the following cash flows. We calculate IRR using hit and trail in the above formula. Alternatively, we can use IRR function in excel.

	Residental	Commerical	Industrial
Year 0	-25	-26.6	-21
Year 1	2	6	4
Year 2	2	6	4
Year 3	2	6	4
Year 4	2	6	4
Year 5	2	6	4
Year 6	2	6	4
Year 7	52	16	14
IRR	16.60%	17.30%	14.20%

Based on IRR, Carlson should select the land for Commerical usage.

NPV of a project is sum of the present and discounted future cash flows. For discounting we can choose current inflation rate ie 8%.

NPV = CF at year 0 + (Cash flow at Year t/(1+r)^t)

					Discounted cash flows
	Residental	Commerical	Industrial	Discounting factor @ 8%	Residental	Commerical	Industrial
Year 0	-25	-26.6	-21	1	-25.00	-26.60	-21.00
Year 1	2	6	4	0.93	1.85	5.56	3.70
Year 2	2	6	4	0.86	1.71	5.14	3.43
Year 3	2	6	4	0.79	1.59	4.76	3.18
Year 4	2	6	4	0.74	1.47	4.41	2.94
Year 5	2	6	4	0.68	1.36	4.08	2.72
Year 6	2	6	4	0.63	1.26	3.78	2.52
Year 7	52	16	14	0.58	30.34	9.34	8.17
				NPV	14.59	10.47	5.66

Based on NPV, Carlson should select the land for Residential usage.