Question

Assume that you are working at a manufacturing company and trying to decide between the following two projects:

	Year-End Cash Flows $ thousands)
Project	0	1	2
A	-27	16	21
B	-77	40	50

Q1. If the cost of capital is 8%, use the incremental IRR rule to make the decision.

Q2. If the cost of capital is the same as the Q1, determine the NPV of each project.

Answer 1

Answer A: Cost of Capital =8%

For Calculating Incremental IRR we have to calculate the difference in project cash flows (B-A) and calculate IRR of that

Year	0	1	2
Cash Flow	-27	16	21
Cash Flow	-77	40	50
Incremental Cash Flow(B-A)	-50	24	29
IRR	4%

To calculate IRR you can use use excel formula

You can also use present value formula = cash flow/(1 + discount rate)^(no of years) to calculate IRR

Discount rate would be such that NPV comes out to be 0

50 = 24/(1+ r)^1 + 29/(1+ r)^2 use trial and error to calculate discount rate here

after putting values you will find Incremental IRR to be around 4%

If the Incremental IRR is higher than required rate of return then project with higher investment rate should be selected but that is not the case here, it is lower than 8% (IRR = 4%) that's why Project A should be chosen i.e. lower investment option

Answer B:

Present value formula = Cash Flow/(1+ Discount rate)^(no of year)

Discount rate = Cost of Capital = 8%

Project A
Year	0	1	2
Cash Flow	-27	16	21
Present value(Cash Flow/(1+0.08)^(no of year))	-27.00	14.81	18.00
NPV (Sum of all present values)	5.82

Project B
Year	0	1	2
Cash Flow	-77	40	50
Present value(Cash Flow/(1+0.08)^(no of year))	-77.00	37.04	42.87
NPV (Sum of all present value)	2.90