Question

2. A company is considering two mutually exclusive expansion projects. Plan A requires a 21 million expenditure on a large scale integrated plant that would provide expected cash flows of $6.40 million per year for 6 years. Plan B requires a $7 million expenditure to build a somewhat less efficient, more labor-intensive plant with expected cash flows of $2.72 million per year for 6 years. The firm’s WACC is 10%. (Timeline required)

a. Calculate each project’s NPV and IRR.

b. Calculate the crossover rate where the two projects’ NPVs are equal

c. Based on your answer to (b), explain when there will be a conflict between NPV and IRR in making capital budgeting decisions regarding mutually exclusive projects.

Answer 1

A .As you can see the NPV=$6.87Mn, & IRR=10% for A

NPV=$4.85Mn, IRR=19% for B

Refer Image attached below:

B: let the cross over rate equals to x

then NPVA=NPVB

6.4/(1+x)+6.4/(1+x)^2+6.4/(1+x)^3+6.4/(1+x)^4+6.4/(1+x)^5-21=2.72/(1+x)+2.72/(1+x)^2+2.72/(1+x)^3+2.72/(1+x)^4+2.72/(1+x)^5-7

3.68/(1+x)+3.68/(1+x)^2+3.68/(1+x)^3+3.68/(1+x)^4+3.68/(1+x)^5=14

Solve for X, or we can plot the values of NPV on y axis with Discount rates on x axis for both plans and find where these 2 project cross each other.

IRR comes out to be approx=14.796%

c) The two possible conflicts are; conflict in differences with scale and timing, and conflict when selecting a project with higher NPV.

NPV is a better method for evaluating mutually exclusive projects than the IRR method. Hence project should be opted for.

NPV also has an advantage over IRR when a project has non-normal cash flows. Non-normal cash flows exist if there is a large cash outflow during or at the end of the project