Question

Question 4

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

a]	PROJECT SQ:
	Year	Cash flow	Cumulative Cash Flow	PVIF at 11%	PV at 11%	PVIF at 16%	PV at 16%	PVIF at 17%	PV at 17%
	0	$      -6,70,000	$   -6,70,000	1	$ -6,70,000	1.00000	$ -6,70,000	1.00000	$ -6,70,000
	1	$        2,50,000	$   -4,20,000	0.90090	$    2,25,225	0.86207	$   2,15,517	0.85470	$    2,13,675
	2	$        2,00,000	$   -2,20,000	0.81162	$    1,62,324	0.74316	$   1,48,633	0.73051	$    1,46,103
	3	$        1,70,000	$       -50,000	0.73119	$    1,24,303	0.64066	$   1,08,912	0.62437	$    1,06,143
	4	$        1,50,000	$     1,00,000	0.65873	$       98,810	0.55229	$      82,844	0.53365	$       80,048
	5	$        1,30,000	$     2,30,000	0.59345	$       77,149	0.47611	$      61,895	0.45611	$       59,294
	6	$        1,30,000	$     3,60,000	0.53464	$       69,503	0.41044	$      53,357	0.38984	$       50,679
					$       87,314		$         1,157		$      -14,058
	Payback period = 3+50000/150000 =	3.33	Years
	NPV =			$         87,314
	IRR is that discount rate which gives 0 NPV. It has to be found out by trial and error by varying the discount rate to get
	0 NPV. It is done in the above table and 0 NPV will be got if the discount rate is between 16% and 17%.
	By simple interpolation, IRR = 16%+1%*1157/(1157+14058) =	16.08%
	PROJECT HT:
	Year	Cash flow	Cumulative Cash Flow	PVIF at 11%	PV at 11%	PVIF at 16%	PV at 16%	PVIF at 15%	PV at 15%
	0	$      -9,40,000	$   -9,40,000	1	$ -9,40,000	1.00000	$ -9,40,000	1.00000	$ -9,40,000
	1	$        1,70,000	$   -7,70,000	0.90090	$    1,53,153	0.86207	$   1,46,552	0.86957	$    1,47,826
	2	$        1,80,000	$   -5,90,000	0.81162	$    1,46,092	0.74316	$   1,33,769	0.75614	$    1,36,106
	3	$        2,00,000	$   -3,90,000	0.73119	$    1,46,238	0.64066	$   1,28,132	0.65752	$    1,31,503
	4	$        2,50,000	$   -1,40,000	0.65873	$    1,64,683	0.55229	$   1,38,073	0.57175	$    1,42,938
	5	$        3,00,000	$     1,60,000	0.59345	$    1,78,035	0.47611	$   1,42,834	0.49718	$    1,49,153
	6	$        5,50,000	$     7,10,000	0.53464	$    2,94,052	0.41044	$   2,25,743	0.43233	$    2,37,780
					$    1,42,254		$     -24,897		$          5,307
	Payback period = 4+140000/300000 =	4.47	Years
	NPV =			$     1,42,254
	By simple interpolation, IRR = 15%+1%*5307/(5307+24897) =	15.18%
b]	The project that would be recommended is 'Project HT' with the higher NPV. It may be noted that it has higher PB and
	lower IRR which, makes it the second choice under PB and IRR methods. But, in case of conflict NPV should prevail.
	Hence, Projecct HT is recommended.
c]	The payback has the following key problems:
	*It does not consider time value of money
	*It ignores the cash flows after the payback period, thereby resulting in loss of PV on cash flows after the payback
	period
	*It does not give the addition to shareholder wealth, which the NPV does.
d]	In the case of scale difference [as in this question], the incremental IRR can be used.
	The first step is to find the incremental cash flows by subtracting the cash flows of the project with the lower initial
	cost from the cash flows of the project with the higher initial cash flowes. In the above example, the cash flows of SW
	can be subtracted from the cash flows of HT. Then we get a single stream of cash flows [that is a single project]. The
	IRR of the differential cash flows is the incremental IRR.
	The decision rule is:
	Incremental IRR>WACC, implement the project with the higher initial investment; if not implement the project with
	the lower investment. The decision would be the same as given by NPV.