Question

Suppose your firm is considering two mutually exclusive, required projects with the cash flows shown below. The required rate of return on projects of both of their risk class is 10 percent. Project A s Cash flow from year 0 to year 3: -1000, 400, 400, 700. Project B s Cash flow from year 0 to year 3: -500, 200, 300, 300. Which statement is correct?

A-Accept A, reject B, because B has lower IRR

B-Reject A, accept B, because B has higher NPV

C-Reject A, accept B, because B has higher IRR

D-Accept A, reject B, because A has higher NPV

Answer 1

Project A

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$1,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for the three year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the required return of 10%.
• Press the down arrow and CPT buttons to get the net present value.

Net present value of cash flows at 10% required return is $220.14.

Internal rate of return is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$1,000 .It is entered with a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR and CPT button to get the IRR of the project.

The IRR of the project A is 20.94%.

Project B

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$500. It is entered with a negative sign since it is a cash outflow.
• Cash flow for the three year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the required return of 10%.
• Press the down arrow and CPT buttons to get the net present value.

Net present value of cash flows at 10% required return is $155.15.

Internal rate of return is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$500 .It is entered with a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR and CPT button to get the IRR of the project.

The IRR of the project A is 25.70%.

Since project A has the higher net present value, project A should be accepted and project B should be rejected.

Hence, the answer is option d.

In case of any further queries, kindly comment on the solution