Question

Dwight Donovan, the president of Donovan 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 four 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 $400,000 and for Project B are $160,000. The annual expected cash inflows are $126,000 for Project A and $52,800 for Project B. Both investments are expected to provide cash flow benefits for the next four years. Donovan Enterprises’ cost of capital is 8 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

please explain and show work

Required

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

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

1) Calculation of Net Present Value

Project A

Initial Investment = $400,000

Present Value of Cash Inflows = Annual Expected Cash Inflows*PVAF(8%, 4 yrs)

= $126,000*3.31213 = $417,328

Net Present Value = Present Value of cash Inflows - Initial Investment

= $417,328 - $400,000 = $17,328

Project B

Initial Investment = $160,000

Present Value of Cash Inflows = Annual Expected Cash Inflows*PVAF(8%, 4 yrs)

= $52,800*3.31213 = $174,880

Net Present Value = Present Value of cash Inflows - Initial Investment

= $174,880 - $160,000 = $14,880

The net present value of Project A (i.e. $17,328) is more than net present value of Project B (i.e. $14,880), hence Project A should be selected.

2) Internal rate of return is the rate at which the present value of cash inflows from the project is equal to present value of cash outflows for the project. The internal rate of return of each project is calculated as follows:-

Project A

Initial Investment = Annual Expected Cash Inflows*PVAF(i%, 4 yrs)

(Where i = Internal rate of return)

$400,000 = $126,000*PVAF(i%, 4 yrs)

PVAF(i%, 4 yrs) = $400,000/$126,000 = 3.17460

From the present value annuity table, the value of i at 4 years for 3.17460 is 10% (approx.)

Therefore internal rate of return for project A is 10%.

Project B

Initial Investment = Annual Expected Cash Inflows*PVAF(i%, 4 yrs)

(Where i = Internal rate of return)

$160,000 = $52,800*PVAF(i%, 4 yrs)

PVAF(i%, 4 yrs) = $160,000/$52,800 = 3.03030

From the present value annuity table, the value of i at 4 years for 3.03030 is 12% (approx.)

Therefore internal rate of return for project A is 12%.

Based on Internal rate of return approach, the project with higher internal rate of return should be selected. Hence project B should be selected based on IRR approach.