Question

Y-Bar uses IRR to evaluate projects. The company has a cost of capital of 15%

They are currently comparing two mutually exclusive projects with the following projected cash flows:

	Project X	Project Y
Initial Investment	-R500 000,00	-R360 000,00
Annual Cash flows
Year 1	R25 000,00	R100 000,00
Year 2	R60 000,00	R60 000,00
Year 3	R250 000,00	R250 000,00
Year 4	R250 000,00	R90 000,00

Based on the information above, which statement is most accurate:

(a) The company will select project Y as it has the highest NPV.

(b) The company will select project Y as it has the highest IRR.

(c) The company will not select either project X or Y on the bases of IRR.

(d) The company will select both project X and Y as the IRR of the projects are very similar.

(e) None of the above

Answer 1

Project X:

Net Present Value:

Cost of Capital = 15%

Net Present Value = -500,000 + 25,000/1.15 + 60,000/1.15^2 + 250,000/1.15^3 + 250,000/1.15^4
Net Present Value = -125,574.88

Internal Rate of Return:

Let IRR be i%

Net Present Value = -500,000 + 25,000/(1+i) + 60,000/(1+i)^2 + 250,000/(1+i)^3 + 250,000/(1+i)^4
0 = -500,000 + 25,000/(1+i) + 60,000/(1+i)^2 + 250,000/(1+i)^3 + 250,000/(1+i)^4

Using financial calculator, i = 4.99%

Internal Rate of Return = 4.99%

Project Y:

Net Present Value:

Cost of Capital = 15%

Net Present Value = -360,000 + 100,000/1.15 + 60,000/1.15^2 + 250,000/1.15^3 + 90,000/1.15^4
Net Present Value = -11,838.01

Internal Rate of Return:

Let IRR be i%

Net Present Value = -360,000 + 100,000/(1+i) + 60,000/(1+i)^2 + 250,000/(1+i)^3 + 90,000/(1+i)^4
0 = -360,000 + 100,000/(1+i) + 60,000/(1+i)^2 + 250,000/(1+i)^3 + 90,000/(1+i)^4

Using financial calculator, i = 13.49%

Internal Rate of Return = 13.49%

Both projects are mutually exclusive; therefore, the company should not accept any project as both projects have negative NPV and both projects have IRR less than 15%.

Therefore, the company will not select either Project X or Y on the bases of IRR.