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 following year, net cash flows of $6,000 per year for 6 years. 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

Year	A	B
0	-10,000	-15,500
1	5,000	6,000
2	-2,000	6,000
3	7,000	-2,000
4	8,000	6,000
5		6,000
6		6,000
NPV	$2,936.50	$3,474.20

Cash Flows are shown in the table above. NPV can be calculated using the same function in excel or calculator with 12% discount rate.

iii) If projects are mutually exclusive, Project A is selected because because it has higher annualized benefit, which can be calculated using PMT function

For A, N = 4, I/Y = 12%, PV = 2,936.50, FV = 0 => Compute PMT = $966.80

For B, N = 6, I/Y = 12%, PV = 3,474.20, FV = 0 => Compute PMT = $845.02

iv) For completely independent projects, both projects should be selected as they have positive NPVs.

v) IRR is not appropriate because cash flows are non-conventional with outflows in the middle of the project lives. It will result in multiple IRR for such projects and hence, we do not use IRR to evaluate such projects.