Question

Consider the following two mutually exclusive projects, you require a 11 percent return on
your investment:
Year Cash Flow (A) Cash Flow (B)
0           -17,000                 -17,000
1             8,000                     2,000
2             7,000                     5000
3              5,000.                   9,000
4              3,000                    9,500
Required:
a) What is the IRR for each of these projects? If you apply the IRR decision rule, which
project should the company accept? Is this decision necessarily correct? (1 mark)
b) What is the NPV for each of these projects? (1 mark)
c) Which project will you choose if you apply the NPV decision rule? (1 mark)
d) Over what range of discount rates would you choose Project A? Project B? At what
discount rate would you be indifferent between these two projects? Explain. (1 mark)
e) What are the problems associated with using the payback period as a means of evaluating
cash flows? (1 mark)
f) What conceptual advantage does the discounted payback method have over the regular
payback method? Can the discounted payback ever be longer than the regular payback?
Explain.

Answer 1

a) IRR (r) of project A is given by

-17000+8000/(1+r)+7000/(1+r)^2+5000/(1+r)^3+3000/(1+r)^4 =0

Using Hit and Trial method or by Excel's SOLVER, the value of r =0.15858 or 15.86%

IRR (r) of project B is given by

-17000+2000/(1+r)+5000/(1+r)^2+9000/(1+r)^3+9500/(1+r)^4 =0

Using Hit and Trial method or by Excel's SOLVER, the value of r =0.14693 or 14.69%

As per IRR rule, one should choose project A as it has higher IRR. This decision is not necessarily correct as NPV is a better decision making criteria.

b) NPV of Project A = -17000+8000/1.11+7000/1.11^2+5000/1.11^3+3000/1.11^4 = $1520.71

NPV of Project B = -17000+2000/1.11+5000/1.11^2+9000/1.11^3+9500/1.11^4 = $1698.58

c) As per the NPV decision rule, Project B should be chosen as it has a higher NPV

d) The rate at which the NPV of both A and B are equal is given by

-17000+8000/(1+r)+7000/(1+r)^2+5000/(1+r)^3+3000/(1+r)^4 =-17000+2000/(1+r)+5000/(1+r)^2+9000/(1+r)^3+9500/(1+r)^4

Solving for r , we get r = 0.1218 or 12.18%

So,

For discount rates lesser than 12.18%, project B will have a higher NPV than project A and we will chose project B

For discount rates higher than 12.18%, project A will have a higher NPV than project B and we will chose project A

and at 12.18%, we would be indifferent between these two projects