Question

Dwight Donovan, the president of Franklin 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 $48,000. The annual expected cash inflows are $46,221 for Project A and $19,302 for Project B. Both investments are expected to provide cash flow benefits for the next three years. Franklin Enterprises’ cost of capital is 8 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Required

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

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

	Net Present Value
Project A
Project B

	Internal Rate of Return
Project A	%
Project B	%

Answer 1

Ans. Calculation of Net present value of the project

Initial Investment of project A = $117000

Initial Investment of Project B = $48000

Annual cash flow for project A = 46221

Annual cashflow for project B = 19302

Present value of Cash inflow of project A = 46221Xcumulative PV @8% for 3yrs

                                                                = 46221X2.58 = $119250

Present value of cash inflow of Project B = 19302X2.58 = $49799

Net Present value = PV of Cashinflow-PV of cashoutflow

Net present value of Project A = (119250-117000) = $2250

Net present value of Project B = (49799-48000) = $1799

Comment: As per Net present value Project A is better than Project B, so Project A should be choose for better return in term of Net present value

b. Calculation of Internal Rate of Return: Minimum rate of return of project

NPV for project A @ 8% cost of capital = 2250

NPV for project B @ 8% cost of capital = 1799

Computation of IRR by trial and error method

By the using of 8% cost of capital, Net present value is coming in positive, now we want NPV in Negative we will choose higher Rate, For example 12%

PV of cashinflow if Rate is 12% for project A = 46221X2.40 = 110930

NPV of project A (110930-117000) = -6070

PV of cashinflow if rate is 12% for Project B = 19302X2.40 = 46325

NPV of Project B (46325-48000) = -1675

Internal Rate of Return (IRR) = Lower Rate + Positive NPV    X Difference in Rate

                                             Positive NPV-Negative NPV

IRR for Project A = 8   + 2250/2250-(-6070)   X (12-8)

                             = (8 + 2250/8320 X 4)X100 = 9.08%

IRR for project B = 8 + 1799/1799-(-1675) X 4

                           = (8+1799/3474 X 4) X100

                          = 10.07%

IRR for project A is = 9.30%

IRR for project B is = 10.07%

Comment: IRR of project B is more than Project A, Means Project B Return is more than project A, As per IRR Approach Project B is better than Project A.

So as per IRR Project B should be Select