Question

Dwight Donovan, the president of Fanning Enterprises, is considering two investment opportunities. Because of limited resources, he will be able to invest in only 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 $104,000 and for Project B are $37,000. The annual expected cash inflows are $40,174 for Project A and $13,223 for Project B. Both investments are expected to provide cash flow benefits for the next four years. Fanning Enterprises’ cost of capital is 8 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Required

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

2. Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach?

Answer 1

Calculation of net present value

net present value = present value of cash inflow-initial investment

present value of cash inflow = cash inflow*PVF @8%,4year

present value of cash inflow = 40174*3.31213 = 133062

net present value = 133062-104000 = 29062

Project B

present value of cash inflow = 13223*3.31213 = 43796

net present value = 43796-37000 = 6796

Project A should be adopted based on NPV

calculation of internal rate of return

Present value factor = initial investment/cash inflow

Project A

present value factor = 104000/40174 = 2.58874

present value factor fall under 20% in present value factor table

therefore Internal rate of return = 20%

Project B

Present value factor = initial investment/cash inflow

present value factor = 37000/13223 = 2.79815

present value factor fall under 16% in present value factor table

therefore Internal rate of return = 16%

Project A should be adopted