Question

Inno Tech Inc. is considering investing in either of two competing projects that will allow the firm to eliminate a production bottleneck and meet the growing demand for its products. The firm’s engineering department narrowed the alternatives down to two – Status Quo (SQ) and High Tech (HT). Working with the accounting and finance managers, the firm’s CFO developed the following estimates of the cash flows for SQ and HT over the relevant six-year time horizon. The firm has an 11 percent required return and views these projects as equally risky.

	Project SQ	Project HT
Initial Outflow (CF0)	$670,000	$940,000
Year (t)	Cash Inflows (CFt)
1	$250,000	$170,000
2	200,000	180,000
3	170,000	200,000
4	150,000	250,000
5	130,000	300,000
6	130,000	550,000

Required:

1. Calculate the net present value (NPV), the internal rate of return (IRR), and the payback period for each project. Indicate which project is the best using NPV, IRR and payback period.

2. Which of the two mutually exclusive projects would you recommend that Inno Tech Inc. undertake? Why?

3. What are the key problems associated with the use of the payback method?

4. Assume a financial manager is calculating the NPV and IRR for two mutually exclusive projects of differing scale. Discuss how the IRR technique can still be utilized to obtain a valid result.

Answer 1