Consider the following cash flows on two mutually exclusive projects for the Bah
ID: 2646522 • Letter: C
Question
Consider the following cash flows on two mutually exclusive projects for the Bahamas Recreation Corporation (BRC). Both projects require an annual return of 15 percent.
Compute the IRR for both projects. (Do not round intermediate calculations. Round your answers to 2 decimal places. (e.g., 32.16))
Based on the IRR, which project should you choose?
Calculate the incremental IRR for the cash flows. (Do not round intermediate calculations. Round your answer to 2 decimal places. (e.g., 32.16))
Based on the incremental IRR, which project should you choose?
Compute the NPV for both projects.(Do not round intermediate calculations. Round your answers to 2 decimal places. (e.g., 32.16))
Based on the NPV, which project should you choose?
Is it consistent with the incremental IRR rule?
Consider the following cash flows on two mutually exclusive projects for the Bahamas Recreation Corporation (BRC). Both projects require an annual return of 15 percent.
Explanation / Answer
ANS:
5.1 The IRR is the interest rate that makes the NPV of the project equal to zero. So, the IRR for each project is:
Deepwater Fishing IRR:
0 = C0+ C1/ (1 + IRR) + C2/ (1 + IRR)2+ C3/ (1 + IRR)3
0 = -$970,000 + $390,000 / (1 + IRR) + $526,000 / (1 + IRR)2 + $440,000 / (1 + IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR = 18.3812%
Submarine Ride IRR:
0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3
0 = -$1,890,000 + $940,000 / (1 + IRR) + $820,000 / (1 + IRR)2 + $790,000 / (1 + IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR = 17.1919%
Based on the IRR rule, the deepwater fishing project should be chosen because it has the higher IRR.
5.2 Ans: Obviously Project I
5.3 . To calculate the incremental IRR, we subtract the smaller project`s cash flows from the larger project`s cash flows. In this case, we subtract the deepwater fishing cash flows from the submarine ride cash flows. The incremental IRR is the IRR of these incremental cash flows. So, the incremental cash flows of the submarine ride are:
Year 0
Year 1
Year 2
Year 3
Submarine Ride
-$1,890,000
$940,000
$820,000
$790,000
Deepwater Fishing
-970,000
390,000
540,000
440,000
Submarine ? Fishing
-$920,000
$550,000
$280,000
$350,000
Setting the present value of these incremental cash flows equal to zero, we find the incremental IRR is:
0 = C0+ C1/ (1 + IRR) + C2/ (1 + IRR)2+ C3/ (1 + IRR)3
0 = -$920,000 + $550,000 / (1 + IRR) + $280,000 / (1 + IRR)2 + $350,000 / (1 + IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
Incremental IRR = 15.008
5.4 For investing-type projects, accept the larger project when the incremental IRR is greater than the discount rate. Since the incremental IRR, 15.008%, is greater than the required rate of return of 15 percent, choose the submarine ride project. Note that this is not the choice when evaluating only the IRR of each project. The IRR decision rule is flawed because there is a scale problem. That is, the submarine ride has a greater initial investment than does the deepwater fishing project. This problem is corrected by calculating the IRR of the incremental cash flows, or by evaluating the NPV of each project
5.5. The NPV is the sum of the present value of the cash flows from the project, so the NPV of each project will be:
Deepwater fishing:
NPV =-$940,000 + $390,000 / 1.14 + $526,000 / 1.142 + $440,000 / 1.143
NPV = $86,169.14
Submarine ride:
NPV =-$1,890,000 + $940,000 / 1.14 + $820,000 / 1.142 + $790,000 / 1.143
NPV = $66,866.93
5.6 Since the NPV of the submarine ride project is greater than the NPV of the deepwater fishing project, choose the submarine ride project. The incremental IRR rule is always consistent with the NPV rule.
5.7 Yes
Year 0
Year 1
Year 2
Year 3
Submarine Ride
-$1,890,000
$940,000
$820,000
$790,000
Deepwater Fishing
-970,000
390,000
540,000
440,000
Submarine ? Fishing
-$920,000
$550,000
$280,000
$350,000
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.