Question

Ibb Inc., a company with expertise in designing Internet-related computer software, is considering two possible capital investments. The first would require an initial investment of $1 million, but is forecast to repay $700,000 each year for two years. The second would require an initial investment of $2 million, but would repay $950,000 per year for three years. The appropriate discount rate (the required return) is 10% per year. Other than these two projects, your firm has no superior investment alternatives. Your goal is to maximize shareholder value. (a) Compute the NPV and the IRR for each project. If Ibbotson must choose between the two projects, which should it take? (b) The manager who provided the cash flow estimates for the first project argues that the company should invest shareholder capital to obtain the highest possible returns, and he asserts that this is project one. Does his argument alter your assessment of which project is better? Explain. (c) The first proposed project involves rice farming in Thailand. The manager who provided the cash flow forecasts is known to relish the idea of a two-year overseas assignment. The second proposed project involves development of software designed to search the Internet to obtain and compare prices for specified goods. Is this information relevant in choosing among the two projects?

Answer 1

lbb Inc. has been provided with 2 projects. It has to choose the best one amongst 2 based on NPV & IRR. Hence, let's calculate NPV & IRR of both the projects.

Project 1	$
Initial cash outflow (a)	-1000000
Year	Cash recovery ($)	Discount factor @10%	Discounted Cash recovery ($)
1	700000	0.909	636363.636
2	700000	0.826	578512.397
Total (b)			1214876.033
NPV (b)-(a)	214876.03
IRR	0.26
Project 2	$
Initial cash outflow(a)	-2000000
Year	Cash recovery	Discount factor @10%	Discounted Cash recovery ($)
1	950000	0.909	863636.364
2	950000	0.826	785123.967
3	950000	0.751	713749.061
Total (b)			2362509.391
NPV (b)-(a)	362509.39
IRR	0.20

So, based on NPV, lbb Inc. should choose project 2, as it's NPV is higher. However, based on IRR, it should choose project 1 as it's IRR is higher.

lbb Inc. is engaged in designing internet related computer software. Therefore, the activity of project 2 which is developement of software designed to search the internet to obtain & compare prices for specified goods is in tandem with the activity of the Company. Activity of project 1 which is rice farming in thailand has nothing to do with the business of the Company. Hence, this information is also relevant in choosing among the project. Project which supports the business of the Company should be choosen. Therefore, Project 2 should be choosen based on this information.