Emmitsburg Brewing Company is considering three mutually exclusive investment al

Question

Emmitsburg Brewing Company is considering three mutually exclusive investment alternatives. Its estimated weightedaverage cost of capital, used as the discount rate for capital budgeting purposes, is 12%. Following is information regarding each of the three projects:

                                                                                     Project A            Project B             Project C

Required investment outlay                                         500,000             100,000               215,000

Incremental after-tax cash inlows/year                        140,000             33,000                 85,000

Estimated project life (years)                                       6                        5                          4

Estimated salvage value (end of life)                          10,000                5,000                  0

(a) Compute the net present value of each project and determine which alternative, based on NPV, is most desirable.

(b) Compute the profitability index (PI) for each alternative and state which alternative, based on PI, is most desirable.

(c) Compute the internal rate of return (IRR) for each alternative and state which alternative, based on IRR, is more

desirable.

(d) Why do the project rankings differ under the three methods of analysis? Which alternative would you recommend,

and why?

Explanation / Answer

Solution:

a) NPV of the projects

A B C

PV of incremental cash inflows 575400 118800 258400

[140000* PVIFA (12%,6)]   [33000* PVIFA (12%,5)]   [85000* PVIFA (12%,4)]

PV of salvage value 5066 2837 -

[10000* PVIF(12%,6)]   [5000* PVIF(12%,5)]

Less: Initial outlay (500000) (100000) (215000)

NPV 80466 21637 43400

Based on NPV, Project A is most desirable.

b) PI = PV of cash inflows/Initial Investment

Project A = (575400 + 5066) /500000 = 1.16

Project B = (118800 + 2837) /100000 = 1.22   

Project C = 258400/215000 = 1.20

Based on PI, Project B is most desirable.

c) IRR is the rate of return at which

PV of cash Inflows= PV of cash outlflows

Project A

Let IRR = 17.45%

So, 140000*PVIFA(17.45%,6) + 10000* PVIF (17.45%,6) = 500000

500458 ~= 500000

Thus, IRR = 17.45%(approx.)

Project B

Let IRR = 21%

So, 33000*PVIFA(21%,5) + 5000* PVIF (21%,5) = 100000

98485 ~= 100000

Thus, IRR = 21%(approx.)

Project C

Let IRR = 21%

So, 85000*PVIFA(21%,4) = 215000

215937 ~= 215000

Thus, IRR = 21%(approx.)

Based on IRR, Project C is most desirable.(because it is the highest rate of return and provides the most approximate answer)

d) When choosing between mutually exclusive projects, difference between NPV, PI and IRR decisions could occur due to:

In case of mutually exclusive projects, the NPV method should be preferred because the NPV indicates the economic contribution of the project. Whenever in conflict, always use NPV. This is because NPV (1) is based on cash flows not accounting data, (2) assumes reinvestment rate at WACC and (3) does not require arbitrary cut-off point.

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