Question

Consider two mutually exclusive R&D projects that Savage Tech is considering. Assume the discount rate for both projects is 8 percent. Project A: Server CPU .13 micron processing project By shrinking the die size to .13 micron, the company will be able to offer server CPU chips with lower power consumption and heat generation, meaning faster CPUs. Project B: New telecom chip project Entry into this industry will require introduction of a new chip for cell phones. The know-how will require a large amount of up-front capital, but success of the project will lead to large cash flows later on.

Year    Project A Project B

0 –$ 705,000 –$ 910,000

1 340,000 255,000

2 355,000 360,000

3 255,000 360,000

4 180,000 410,000

5 120,000 495,000

Complete the following table: (Do not round intermediate calculations. Enter the IRR as a percent. Round your profitability index (PI) answers to 3 decimal places, e.g., 32.161, and other answers to 2 decimal places, e.g., 32.16.)

Project A Project B

NPV $ $

IRR   % %

PI

What is the incremental IRR of investing in the larger project? (Do not round intermediate calculations. Enter your answer as a percent and round your answer to 2 decimal places, e.g., 32.16.)

Incremental IRR %

Answer 1

Project A
Discount rate	8.000%
Year	0	1	2	3	4	5
Cash flow stream	-705000	340000	355000	255000	180000	120000
Discounting factor	1.000	1.080	1.166	1.260	1.360	1.469
Discounted cash flows project	-705000.000	314814.815	304355.281	202427.221	132305.374	81669.984
NPV = Sum of discounted cash flows
NPV Project A =	330572.67
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
PI= (NPV+initial inv.)/initial inv.
=(330572.67+705000)/705000
1.47
Project A
IRR is the rate at which NPV =0
IRR	28.07%
Year	0	1	2	3	4	5
Cash flow stream	-705000.000	340000.000	355000.000	255000.000	180000.000	120000.000
Discounting factor	1.000	1.281	1.640	2.101	2.691	3.446
Discounted cash flows project	-705000.000	265470.986	216423.615	121382.092	66899.842	34823.465
NPV = Sum of discounted cash flows
NPV Project A =	0.000
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
IRR=	28.07%

Project B
Discount rate	8.000%
Year	0	1	2	3	4	5
Cash flow stream	-910000	255000	360000	360000	410000	495000
Discounting factor	1.000	1.080	1.166	1.260	1.360	1.469
Discounted cash flows project	-910000.000	236111.111	308641.975	285779.607	301362.240	336888.683
NPV = Sum of discounted cash flows
NPV Project B =	558783.62
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
PI= (NPV+initial inv.)/initial inv.
=(558783.62+910000)/910000
1.61
IRR False False Center Center
Project B
IRR is the rate at which NPV =0
IRR	26.86%
Year	0	1	2	3	4	5
Cash flow stream	-910000.000	255000.000	360000.000	360000.000	410000.000	495000.000
Discounting factor	1.000	1.269	1.609	2.042	2.590	3.286
Discounted cash flows project	-910000.000	201009.843	223695.264	176333.137	158304.199	150657.557
NPV = Sum of discounted cash flows
NPV Project B =	0.000
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
IRR=	26.86%

Cashflow difference to calculate incremental IRR as follows

Project B-A
Year	Cash flow stream
0	-205000
1	-85000
2	5000
3	105000
4	230000
5	375000

Project B-A
IRR is the rate at which NPV =0
IRR	25.12%
Year	0	1	2	3	4	5
Cash flow stream	-205000.000	-85000.000	5000.000	105000.000	230000.000	375000.000
Discounting factor	1.000	1.251	1.566	1.959	2.451	3.066
Discounted cash flows project	-205000.000	-67934.562	3193.844	53604.945	93845.888	122289.884
NPV = Sum of discounted cash flows
NPV Project B-A =	0.000
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
IRR=	25.12%