Ramboski, LLC, has identified the following two mutually exclusive projects: a)
ID: 2648199 • Letter: R
Question
Ramboski, LLC, has identified the following two mutually exclusive projects:
a) What is the IRR for each of these projects? If you apply the IRR decision rule, which project should the company accept? Is this decision necessarily correct?
b) If the required return is 11 percent, what is the NPV for each of these projects? Which projects will you choose if you apply the NPV decision rule?
c) Over what range of discount rates would you choose Project A? Project B? At what discount rate would you be indifferent between these two projects? Explain.
year cash flow (A) cash flow (B) 0 -65,000 -65,000 1 34,000 19,000 2 27,000 25,000 3 21,000 29,000 4 17,000 34,000Explanation / Answer
a) For calculating IRR, first we have to calculate NPV:
NPV at 11%.
Project A
NPV = Outflow - PV of Inflow
NPV = 65,000 - 79,096.90 = $14,096.90
Project B
NPV = Outflow - PV of Inflow
NPV = 65,000 - 81,007.70 = $16,007.70
Both the Projects have Positive NPV at 11%, it means IRR must be Greater than 11%.
We take 30%:
NPV at 30%.
Project A
NPV = Outflow - PV of Inflow
NPV = 65,000 - 57,639.60 = -$7,360.40
IRR by Interpolation: Lowest Discount Rate + [ NPV at Lower Rate x (Higher Rate - Lower Rate) / (NPV at Lower Rate - NPV at Higher Rate)]
IRR = 0.11 + [ 14,096.90x (0.30 - 0.11) / {14,096.90 - (-7,360.40)} ]
IRR = 23.48%
Project B
NPV = Outflow - PV of Inflow
NPV = 65,000 - 54,511.50 = -$10,488.50
IRR by Interpolation: Lowest Discount Rate + [ NPV at Lower Rate x (Higher Rate - Lower Rate) / (NPV at Lower Rate - NPV at Higher Rate)]
IRR = 0.11 + [ 16,007.70 X (0.30 - 0.11) / {16,007.70 - (- 10,488.50)}]
IRR = 22.48%
According to IRR Rule, Company should accept project A because it has Higher IRR. But this decision need not to be correct because in many situation, IRR does not give true result.
b) NPV of Project A = $14,096.90
NPV of project B = $16,007.70
According to NPV rule at 11%, Project B should be accepted because it has Higher NPV.
c) By, Trial and Error we find that at 16.30% Discounting Rate, Both the Project has Same NPV, So, at this point we will be indifferent between the Two Project. At discount Rates below this, Project B is prefereable and Discount Rates Above this Project A is prefereable.
0 1 2 3 4 Outflow -65,000 Inflow 34,000 27,000 21,000 17,000 DF(11%) 0.9009 0.8116 0.7312 0.6587 PV 30,630.60 21,913.20 15,355.20 11,197.90 Total PV 79,096.90Related Questions
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