Question

1. NPV of A: $17,328.00
2. Rate of return of B: 12%

Problem 10-19A Using net present value and internal rate of return to evaluate investment opportunities

Dwight Donovan, the president of Donovan 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 employeesPage 472 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 Enterprises’ desired rate of return is 8 percent.

Use Excel®—showing all work and formulas—to compute the following:

1. Compute the net present value of each project. (Round your computations to 2 decimal points.)
2. Compute the approximate internal rate of return for each project. (Round your rates to 6 decimal points.)

Showing the comparison of the net present value approach with the internal rate of return approach calculated above. Complete the following in your presentation:

1. Analyze the results of the net present value calculations and the significance of these results, supported with examples.
2. Determine which project should be adopted based on the net present value approach and provide rationale for your decision.
3. Analyze the results of the internal rate of return calculation and the significance of these results, supported with examples.
4. Determine which project should be adopted based on the internal rate of return approach and provide rationale for your decision.
5. Determine the preferred method in the given circumstances and provide reasoning and details to support the method selected.
6. Synthesize results of analyses and computations to determine the best investment opportunity to recommend to the president of Donovan Enterprises.

Answer 1

A. NPV analysis and its significance :-

Net Present value is calculation of All the outflow of cash and inflow of cash being bring at the value of today ( Zero Time) to understand that whethe we should take the decision or drop it. NPV calculation is a tool to understand that what our outcomes will stand if they all happen today, so it helps people to understand that whether decision will make profit for them or make loss.

I have already told you that it is just a tool for calculations of present value of future cash outflows and inflows. Many times calculation of NPV is not significant. E.g. If market price of a product is going down to the level of cost of production of that product than in that situation there is only 2 option, make an investment to make cost of production lower or shut down the business. So in this situation any kind of tool like NPV or IRR will not help and calculating them will have no impact on decision.

2. Decision on the basis of NPV :-

For both of the options we have calculated NPV and the results are presented above. NPV is the total value of Cash inflow at the present time i.e. Zero point. NPV primarily seeks to identify the most viable investment opportunities by comparing the present value of future cash flows of projects. The rationale behind the NPV method is its focus on the maximization of wealth. So if we compare the both the option than we should go for Option A. Option A has NPV of $17,327.98 which is very much as compared to the NPV of option B so it will maximise the wealth and profit for the organisation as compared to Option B.

3. IRR and its significance :-

IRR measures how well a project, capital expenditure or investment performs over time. It helps to compare one investment to another or determine whether or not a particular project is viable.The internal rate of return is the interest rate that occurs when the net cash related to the investment equals zero. Calculating the IRR will show if your company made or lost money on a project. The IRR makes it easy to measure the profitability of your investment and to compare one investment's profitability to another. If the IRR is better than average or exceeds your company’s cost of capital, then invest in the project. If choosing between multiple investments, choose the investment with the highest IRR, assuming all exceed the cost of capital, which is a combination of the cost of your company's long-term debt, preferred stock, if it has any, and shareholder’s equity.

4. Decision on the basis of IRR:-

In information above we have calculated IRR for both the option above. IRR of Option B is 12.110% where IRR of Option A is 9.931%. So it is clear that we should go for Option B because it has higher IRR. IRR is calculation of Return when inflows and outflows are made equal. In simple words we can say that IRR is the Rate of Profit on every Single $ spent on investment. So even though option B is having only $ 372.05 NPV but it has return of 12.110% on every $ spent in investment. So we should go for Option B.

5. Preferred Method for Investment Decision :-

Mutually exclusive projects are projects in which acceptance of one project excludes the others from consideration. In case of mutually-exclusive projects, an NPV and IRR conflict may arise in which one project has a higher NPV but the other has higher IRR. The conflict either arises due to relative size of the project or due to the different cash flow distribution of the projects. Since NPV is an absolute measure, it will rank a project adding more dollar value higher regardless of the initial investment required. IRR is a relative measure, and it will rank projects offering best investment return higher regardless of the total value added.

  Whenever an NPV and IRR conflict arises, always accept the project with higher NPV. It is because IRR inherently assumes that any cash flows can be reinvested at the internal rate of return. This assumption is problematic because there is no guarantee that equally profitable opportunities will be available as soon as cash flows occur. NPV, on the other hand, does not suffer from such a problematic assumption because it assumes that reinvestment occurs at the cost of capital, which is conservative and realistic. So in case of conflict between these 2 always go for NPV because it has realistic results.

6. Decsion suggestion for President of Donovan Enterprises :-

In all above answers and solutions we have discussed everything about NPV and IRR for both the projects. We have discussed than in case of mutually exclusive options always go for Option having highest NPV.

So we would suggest the President of Donovan Enterprises that he should go for Option A i.e. Purchase of Machinery.