Question

Question 1

The financial management team of a large business is considering undertaking one of three mutually exclusive investment projects. Details on each project are provided below:

Project 1:

The project will require an initial investment of $400,000 today and is expected to result in cash inflows of $90,000 per year for 9 years. The first cash inflow will occur in 3 years’ time.

Project 2:

The project will require and initial investment of $300,000 today and is expected to result in cash inflows of $30,000 per year for the foreseeable future. The first cash inflow will occur immediately.

Project 3:

The project will require two investments, one today and another in one years’ time. The expected cash flows are detailed below:

T0	T1	T2	T3	T4
($100,000)	($150,000)	$170,000	$150,000	$30,000

The company’s cost of capital is 9%.

1. Calculate the net present value (NPV) of each project and recommend which project should be undertaken.

2. Explain why NPV should be used in preference to internal rate of return (IRR) when choosing between mutually exclusive investment projects.

(4 marks, maximum 200 words)

Answer 1

Calculation of NPV of Project 1
Cash Flow	Period	Amount	P.V.A.F @ 9%	N.P.V @ 9%
Cash Outflow	0	-400000	1	-400000
Annual Cash Flow	3-11	90000	5.0461	454149
			Total	54149
Calculation of NPV of Project 2
Present Value of perpetuity Cash inflows=	Cash inflows/Required rate of return
			=(30000)/9%
			333333
		NPV=	(333333-300000)
		NPV=	33333
Calculation of NPV of Project 3
Cash Flow	Period	Amount	P.V.F @ 9%	N.P.V @ 9%
Cash Outflow	0	-100000	1	-100000
Cash Outflow	1	-150000	0.9174	-137610
Annual Cash Flow	2	170000	0.8417	143089
Annual Cash Flow	3	150000	0.7722	115830
Annual Cash Flow	4	30000	0.7084	21252
			Total	42561
Recommendations:	Project A should be undertaken as it is having greatest NPV.
In the case of mutually exclusive projects it is always suggested to go ahead with NPV method as it shows the amount of real gain for the company. NPV method is a better indicator of Profitability and by calculations always return to correct accept or reject decision regardless of size of the project or timing of the cash flows.