Question

You need to consider two projects which have the following cash flows:

Project A requires an initial investment of $10,000 and will generate net cash flows of $5,000 at the end of year 1, $6,000 at the end of year 2, $7,000 at the end of year 3, and $8,000 at the end of year 4. At the end of year 2, maintenance costs of $8,000 will have to be disbursed.

Project B requires an initial investment of $15,500 and will generate starting at the end of each year, net cash flows of $6,000 per year for 6 years (first cash flow in year 1). It will incur maintenance costs of $8,000 at the end of year 3.

Assume that the required return is 12% per annum for both projects.

i. Draw timeline showing the cash flows of projects A and B?

ii. Find the NPV of projects A and B?

iii. Which project should be chosen if Projects A and B are mutually exclusive? Explain.

iv. Which project should be chosen if the Projects A and B are completely independent? Explain.

v. Based on the cash flows of project A, explain why IRR is not an appropriate evaluation technique for this project?

Answer 1

i.

ii.

Project A
Year	Cash Flow(C)	PV Factor calculation	PV Factor(F) @ 12%	PV( C x F)
0	$        (10,000)	1/(1+0.12)^0	1	$           (10,000.00)
1	$            5,000	1/(1+0.12)^1	0.892857143	$                4,464.29
2	$          (2,000)	1/(1+0.12)^2	0.797193878	$              (1,594.39)
3	$            7,000	1/(1+0.12)^3	0.711780248	$                4,982.46
4	$            8,000	1/(1+0.12)^4	0.635518078	$                5,084.14
			NPV	$                2,936.50

Project B
Year	Cash Flow(C)	PV Factor calculation	PV Factor(F) @ 12%	PV( C x F)
0	$       (15,500)	1/(1+0.12)^0	1	$           (15,500.00)
1	$          6,000	1/(1+0.12)^1	0.892857143	$                5,357.14
2	$           6,000	1/(1+0.12)^2	0.797193878	$                4,783.16
3	$          (2,000)	1/(1+0.12)^3	0.711780248	$              (1,423.56)
4	$            6,000	1/(1+0.12)^4	0.635518078	$                3,813.11
5	$            6,000	1/(1+0.12)^5	0.567426856	$                3,404.56
6	$            6,000	1/(1+0.12)^6	0.506631121	$                3,039.79
			NPV	$                3,474.20

iii.

Based on NPV, Project B should be chosen if both projects are mutually exclusive as NPV of Project B is higher than Project A.

iv.

Based on NPV, both projects should be chosen if projects are independent as both the projects having positive NPV.

v.

Project A has two negative cash flow i.e. initial investment and year two maintenance cost which results in to two IRR values. For the reason of multiple IRR values of both the projects, IRR is not an appropriate evaluation technology for the projects.