Question

3. There are 3 mutually exclusive investments: A, B, and C, which of the 3 should be chosen if you can only choose one? Suppose you are restricted only to investing a total of 11,000, what would you do?   Assume a cutoff of 10%.

Investment	0	1	2	3	IRR (%)
A	(1,000)	505	505	505	24
B	(10,000)	2,000	2,000	12,000	20
C	(11,000)	5,304	5,304	5,304	21

Answer 1

We can go for either investing in either project A plus project B or project C. Because sum of investment in project A plus B = -11000 and project C = -11000. We can investment maximum of -11000 only.

IRR decision rule should be gnored for project selection criteria because IRR doesn’t direct to a right decision when we have limit to invest and cut off rate (cost of capital).

Cut off rate or cost of capital = 10%

Let’s combine the cash flow of project A and B to get desired net cash flow:

Particulars	0	1	2	3
Project A	-1000	505	505	505
Project B	-10000	2000	2000	12000
Project A + B	-11000	2505	2505	12505

NPV = - Initial investment + Sum of the present value of future cash flows

NPV of A plus B = -11000 + 2505/(1+10%)^1 + 2505/(1+10%)^2 + 12505/(1+10%)^3

NPV of A plus B = $2,742.71

Now, let’s calculate NPV of project C:

NPV of C = -11000 + 5304/(1+10%)^1 + 5304/(1+10%)^2 + + 5304/(1+10%)^3

NPV of C = $2,190.26

Based on NPV we should select higher NPV project i.e A plus B combination which results in NPV of $2,742.71

Note: If we would have bases IRR as criteria then we would have selected project C as the best option.