Question

Dwight Donovan, the president of Stuart Enterprises, is considering two investment opportunities. Because of limited resources, he will be able to invest in only one of them. Project A is to purchase a machine that will enable factory automation; the machine is expected to have a useful life of three years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $117,000 and for Project B are $46,000. The annual expected cash inflows are $55,543 for Project A and $19,152 for Project B. Both investments are expected to provide cash flow benefits for the next three years. Stuart Enterprises’ cost of capital is 8 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Required

1. Compute the net present value of each project. Which project should be adopted based on the net present value approach?

2. Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach?

Answer 1

a.Project A

Net present value can be solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$117,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.  
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the cost of capital of 8%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.  

Net present value at 8% cost of capital is $26,139.70.

Project B

Net present value can be solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$46,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.  
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the cost of capital of 8%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.  

Net present value at 8% cost of capital is $3,356.56.

Based on the net present value approach, project A should be adopted since it generates the highest net present value.

b.Project A

Internal rate of return can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$117,000. The initial cash flow is indicated by a negative sign since it is a cash outflow.  
• Cash flow for each of the fifteen years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR and CPT button to get the IRR of the project.

The IRR of the project is 20%.

Project B

Internal rate of return can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$46,000. The initial cash flow is indicated by a negative sign since it is a cash outflow.  
• Cash flow for each of the fifteen years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR and CPT button to get the IRR of the project.

The IRR of the project is 11.9998% 12%.

Based on the internal rate of return approach, project A should be adopted since it generates the largest internal rate of return.