Question

1.

Turbomachinery Parts, Inc. is considering two mutually exclusive equipment investments that would increase its production capacity. The firm uses a 14% cost of capital to evaluate its projects. The two investments have the following cash flows:

Year                            Investment D             Investment E

                        0                                -$50,000                                  -$50,000

                        1                                   24,000                                     15,000

                        2                                   24,000                                     15,000

                        3                                   24,000                                     15,000

                        4                                   - 0 -                                          15,000

                        5                                   - 0 -                                          15,000

                        6                                   - 0 -                                          15,000

a.         Calculate the NPV and IRR for Investments D and E. Using the NPV and IRR rules, what decision would you make?

                       

b.         Use the uniform annuity series (also called the equivalent annual annuity) method to make your decision. How does your decision compare to the one made in part 1?

Answer 1

Answer
a)	Cost of Capital = 14%
Year	Investment D	PV of Cash flows		Investment E	PV of Cash flows
0	-50000.00	-50000.00		-50000.00	-50000.00
1	24000.00	21052.63		15000.00	13157.89
2	24000.00	18467.22		15000.00	11542.01
3	24000.00	16199.32		15000.00	10124.57
4	-	-		15000.00	8881.20
5	-	-		15000.00	7790.53
6	-	-		15000.00	6833.80
NPV		5719.17			8330.01
IRR		20.71%			19.91%
Note : We derived IRR with the help of BA Plus calculator
Investment E has highest NPV but lower IRR than Investment D
NPV shows the amount of wealth created by the project while IRR is the relative measure of return generated by the project. In case of conflict between IRR and NPV for mutually exclusive projects, the project with the highest NPV should be chosen as it will create higher wealth in terms of dollar. Therefore Company should choose Investment E
b)	EAA =	r * NPV
		1 - (1+r)^-n
	Investment D			Investment E
	EAA =	0.14 * 5719.17		0.14 * 8330.01
		1- (1+0.14)^-3		1- (1+0.14)^-6
	EAA =	2463.43		2142.12
EAA provides a single average cash flow for all periods that equal the project’s NPV when discounted
If repetition of project is allowed i.e. After 3 year the company can do one more project with similar cash flow for next 3 year making it comparable to Investment E of 6 year, in such case we choose the project with higher EAA. Hence on the basis of EAA, we should choose Investment D