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)

Total for the question 10 marks

Answer 1

a).

Project 1:

NPV for a time period of n can be calculated using the formula: -C+C1/(1+r)+C2/(1+r)^2+....Cn/(1+r)^n; where C is the initial investment, C1 to Cn are cash inflows and r is the required rate of return

So, NPV of Project A= -400000+90000/(1+9%)^3+90000/(1+9%)^4+...90000/(1+9%)^11

we can use present value of annuity formula for cashinflows which is P*(1-(1+r)^-n)/r

= -400000+ 90000*(1-1.09^-11)/0.09 -90000/(1+9%)-90000/(1+9%)^2

= -400000+ 90000*(6.8052) -90000/(1+9%)-90000/(1+9%)^2

= $54147.14

Project 2:

Given Initial Investment is 300000 and cashinflows are 30000 for foreseeable future.

So, NPV= -300000+30000/(1+9%)+30000/(1+9%)^2+......

= -300000+30000/9% (we used the formula present value of perpetuity= D/r)

-300000+333333.33= $33333.33

Project 3:

From the given cashflows, NPV= -100000-150000/(1+9%)+170000/(1+9%)^2+150000/(1+9%)^3+30000/(1+9%)^4

= -100000-137614.68+143085.59+115827.52+21252.76

= $42551.20

b).

when choosing mutually exclusive projects, NPV is the better decision taking criterion compared to IRR, because of the inhefent flaws in assumptions of IRR. IRR assumes that positibe cashflows can be reinvested at IRR, internal rate of return which is highly unrealistic. They can usually be invetsed at the cost of capital of the firm. In some project evaluations, it gives back multiple IRR values. Because of these issues, NPV is preferred.