Question

Dayan Plc: Investment decisons

Suzy is a company located in Duabi. The company manufactures machine parts in Oman. It is currently involved in making a decsion concerning the acquisition of new machining tool. Two different versions of the tool are available: Y & Z. The results of NPV and IRR of the two alternatives are summarized below:

Tools Net Present Value (NPV) Internal Rate of Return (IRR)

Y AED 68.36m 10.5%

Z AED 55.52m 14.6%

Suzy faces a perfect capital market, in which the interest rate for the projects' risk level is 6%.

Required:

(a) On the basis of NPV and IRR findings above, formulate your investment decision advice.

(b) Using NPV decision rule for mutually exclusive projects, indicate which tools the company shoud accept.

(c) Using IRR decison rule for mutually exclusive projects, indicate which tools the company should accept.

(d) Do your conclusion in (b) and (c) similar? If no, which one is more superior to the other?

(e) State clearly any limitations and assumptions that you made in your calculations.

Answer 1

Whenever there is a conflict in ranking of projects based on NPV and IRR, it is safer to always prefer the NPV ranking. This is due to the realistic assumption and theoretical soundness of the method.

a) On the basis of NPV, tool Y having Net present value of AED 68.36m should be selected.

On the basis of IRR, tool Z with higher IRR will be selected.

This is since because higher the NPV and higher the IRR, greater the amount by which it exceeds the cost of capital, the higher the net cash flows to the investor.

b)Mutually exclusive projects are projects in which acceptance of one project excludes the others from consideration.

Using NPV decision rule for mutually exclusive projects - Tool Y with Higher NPV selected

c)Using IRR decison rule for mutually exclusive projects - Higher the IRR, high the fesibility of the project.So Tool Z is selected.

d). No.

Decesion in (b) and (c) are different because on coparrison based on NPV tool Y is selected while on comparssion based on IRR Tool Z is selected.

Since NPV is an absolute measure and IRR is a relative measure Tool Y is more superior to tool Z.

e). NPV vs IRR conflict also arises due to the different cash flow distribution. IRR inherently assumes that any cash flows can be reinvested at the IRR. This assumption is unrealistic because there is no guarantee that reinvestment at IRR can be achieved. NPV on the other hand assumes reinvestment at the cost of capital, which is conservative and realistic.