Question

Pleas use Excel®—showing all work and formulas (attach excel sheet please)

Dwight Donovan, the president of Donovan Enterprises is considering two investment opportunities. Because of limited resources he will be able to only invest in 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 four 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 $400,000 and for Project B are $160,000. The annual expected cash inflows are $126,000 for Project A and $52,800 for Project B. Both investments are expected to provide cash flow benefits for the next four years. Donovan Enterprise desired rate of return is 8 percent.

Required A) Compute the net present value of each project. Which project should be adopted based on the net present value approach?

B) Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach? Round your rates to six decimal points.

C)Compare the net present value approach with the internal rate of return approach.Which method is better in the given circumstances? Why?

Answer 1

a) Net Present value

The net present value of Project A is more than that of Project B hence Project A should be adopted

b) Internal rate of return

IRR calculated using excel

The formula for calculating IRR in excel is =IRR(cash flows) i.e.Year 0 to year 4

IRR calculated using alternative method

Internal rare of return is the discounting rate at which NPV is zero

Steps for calculating IRR under this method

a) Find the discounted cash inflows at any two rates (one rate should give values that are greater than the cash outflow and the another rate should give values that are lower than the cash outflow at year 0)

b) Use the formula

Discount rate that gives value greater than the cash outflow (i.e. 9% for A and 12% for B)

+

[ Discounted value of that point (i.e. 9% for A and 12% for B) - Cash outflows

/

Discounted value of that point (i.e. 9% for A and 12% for B) - discounted value of other point (i.e.10% fro A and 13% fro B) ]

As per IRR approach Project B should be selected, since the rate is higher than that of A

c) Comparison

Under the IRR method project B is beneficial to undertake whereas as per the NPV method project A is beneficial.

Project B would be more beneficial to undertake since there are only marginal differences between the other project with regard to NPV and at the same time this requires a substantially lesser investment than that of Project A

Since the discount rate used for NPV calculations are only estimates and the IRR method also doesn't take into account changing factors, everything depends on the management's decision of how much to invest and their appetite for risk taking.