Question

Comparing Investment Criteria. Consider the following cash flows of two mutually exclusive projects for Spartan Rubber company.  Assume the discount rate for both projects is 10 percent.

a. Based on the payback period, which project should be taken?

b. Based onthe NPV, which project should be taken?

c.  Based on the IRR, which project should be taken?

d.  Based on the above analysis, is incremental IRR analysis necessary?  If yes, please conduct the analysis.

Year	Dry Prepreg	Solvent Prepreg
0	(1,800,000)	(925,000)
1	690,000	565,000
2	430,000	410,000
3	1,400,000	340,000

Answer 1

Part A

Payback period of Dry prepreg:

Payback period = 2 + 680,000/ 1,400,000

Payback period = 2.49 years

Payback period of Solvent prepreg:

Payback period = 1 + 360,000/ 410,000

Payback period = 1.88 years

As payback period of Solvent Prepreg is less as compared to dry prepreg, we will choose Solvent Prepreg project

Part B

NPV of Project Dry Prepreg

NPV = -1,800,000 + 690,000/ 1.1 + 430,000/ 1.1² + 1,400,000/ 1.1³

NPV = -1,800,000 + 627,272.73 + 355,371.90 + 1,051,840.72

NPV = 234,485.35

NPV of Project Solvent Prepreg

NPV = -925,000 + 565,000/ 1.1 + 410,000/ 1.1² + 340,000/ 1.1³

NPV = -925,000 + 513,636.36 + 338,842.98 + 255,447.03

NPV = 182,926.37

As NPV of Dry Prepreg is more, we will choose Dry Prepreg project

Part C

IRR of Project Dry Prepreg

1,800,000 = 690,000/ (1 + r) + 430,000/ (1 + r)² + 1,400,000/ (1 + r)³

IRR = 16.34%

IRR of Project Solvent Prepreg

925,000 = 565,000/ (1 + r) + 410,000/ (1 + r)² + 340,000/ (1 + r)³

IRR = 22.06%

As IRR of Solvent Prepreg is more and is also high than required rate of return of 10%, we will choose Solvent Prepreg project

Part D

Incremental IRR:

Net cash flows:

CF0 = -875,000

CF1 = 125,000

CF2 = 20,000

CF3 = 1,060,000

IRR:

875,000 = 125,000/ (1 + r) + 20,000/ (1 + r)² + 1,060,000/ (1 + r)³

IRR = 12.33%

For investing-type projects, accept the larger project when the incremental IRR is greater than the discount rate which is true in this case we will choose dry prepreg project