Question

Year Plant Expansion Product Intro  

0 -$3,200,000 -$500,000
1 $1,500,000 $375,000
2 $2,250,000 $275,000
3 $2,500,000 $350,000
4 $2,500,000 $300,000

The High-Flying Growth Company (HFGC) has been growing very rapidly in recent years, making its shareholders rich in the process. The average annual rate of return on the stock in the last few years has been 25%, and HFGC managers believe that 25% is a reasonable figure for the firm's cost of capital. To sustain a high growth rate, the HFGC CEO argues that the company must continue to invest in projects that offer the highest rate of return possible. Two projects are currently under review. The first is an expansion of the firm's production capacity, and the second project involves introducing one of the firm's existing products into a new market. Cash flows from each project appear in the above table

a. Calculate the NPV for both projects. Rank the projects based on their NPVs. (Round to the nearest dollar.)

b. Calculate the IRR for both projects. Rank the projects based on their IRRs. (Round to the nearest dollar.)

c. Calculate the PI for both projects. Rank the projects based on their PIs. (Round to the nearest dollar.)

d. The firm can only afford to undertake one of these investments. What do you think the firm should do?

Answer 1

The cash flows and answers are as under

Year	Expansion	Intro
0	-3200000	-500000
1	1500000	375000
2	2250000	275000
3	2500000	350000
4	2500000	300000
NPV	$1,744,000.00	$278,080.00
Ranks	1	2
IRR	50.73%	55.38%
Ranks	2	1
PI	1.545	1.55616
Ranks	2	1

d: The company should take up Expansion since it is adding to the net value of the company in dollar terms thereby increasing the wealth of shareholders.

WORKINGS