Question

NPV Versus Internal Rate of Return

Keating Hospital is considering two different low-field MRI systems: the Clearlook System and the Goodview System. The projected annual revenues, annual costs, capital outlays, and project life for each system (in after-tax cash flows) are as follows:

	Clearlook	Goodview
Annual revenues	$720,000	$900,000
Annual operating costs	445,000	655,000
System investment	900,000	800,000
Project life	5 years	5 years

Assume that the cost of capital for the company is 8 percent.

The present value tables provided in Exhibit 19B.1 and Exhibit 19B.2 must be used to solve the following problems.

Required:

1. Calculate the NPV for the Clearlook System.
$

2. Calculate the NPV for the Goodview System.
$

Which MRI system would be chosen?

3. What if Keating Hospital wants to know why IRR is not being used for the investment analysis? Calculate the IRR for each project. Round the discount factor to three decimal places. Round the IRR to the nearest whole percentage value (for example, 10.6% rounds to 11% and should be entered as "11" in the answer box.)

	Discount factor	IRR
Clearlook:		%
Goodview:		%

Answer 1

Hi,

Net Present Value of Clear Look and Good View :

	Clear look	Good view
Annual Revenues	$7,20,000	$9,00,000
Less:
Annual Operating Cost	$4,45,000	$6,55,000
Net Inflows	$2,75,000	$2,45,000
PVAF (8%, 5 years)	3.993	3.993
Present value of inflows	$10,97,995	$9,78,214
Less : System Investment	$9,00,000	$8,00,000
Net Present Value	$1,97,995	$1,78,214

Keating Hospital would chose Clear look MRI system as its Net Present Value is higher.

In respect to question no. 3, IRR is not used for investment analysis because

NPV is a better method for evaluating mutually exclusive projects than the IRR method.

The Net Present Value (NPV) Method is method of ranking investment proposals using the NPV, which is equal to the present value of future net cash flows, discounted at the marginal cost of capital

Internal rate of Return is the rate that forces NPV to equal 0 .

The NPV method employs more realistic reinvestment rate assumptions and is a better indicator of profitability and shareholder wealth thus help in making the correct accept-or-reject decision regardless of whether the project experiences non-normal cash flows or if differences in project size or timing of cash flows exist.

IRR of both the MRI system would be :

	Clear look	Good view
Net Inflows	$2,75,000	$2,45,000
PVAF (IRR%, 5 years)	3.273	3.265
Present value of inflows	$9,00,000	$8,00,000
Less : System Investment	$9,00,000	$8,00,000
Net Present Value	$0	$0
IRR	16.021%	16.118%

Hope answer bring more conceptual clarity and solve your purpose.

Thanks.