IRR, NPV, and Profitability Index. Consider two projects that your company is ev
ID: 2654640 • Letter: I
Question
IRR, NPV, and Profitability Index. Consider two projects that your company is evaluating. Project A has cash flows of -25, +11, +12, and +10 at time-zero, one year from now, two years from now, and three years from now, respectively. Project B has cash flows of -50, +22.5, +21.5, and +20.5 at time-zero, one year from now, two years from now, and three years from now, respectively. For the risk of these projects, the appropriate discount rate is 10%.
What is the NPV and IRR of each project?
What is the Profitability Index (PI) of each project, where the appropriate discount rate (the cost of capital) is 10%? If you firm is subject to limited capital to invest (capital rationing), what does your PI suggest about which project you would likely prefer?
Now, alternatively, assume that these two projects are mutually exclusive such that your company can choose only one of the two projects. Should your company choose Project A or Project B?
Explanation / Answer
NPV of Project A = 2.421
NPV of Project B = 3.608
IRR Calculation:
NPV @ 20%
NPV of Project A @ 20% = -1.719
NPV of Project B @ 20% = -4.466
IRR Project A = 10+ [2.421/2.421-(-1.719)] = 10.58%
IRR Project B = 10 + [3.608/3.608-(-4.466)] = 10.45%
PI = Present Value of Cash inflows / Present Value of Cash ouflows
Project A = 27.421/25 = 1.0968
Project B = 53.608/50 = 1.0722
If the firm is subject to limited capital to invest (capital rationing), PI suggests that Project A should be preferred.
If the two projects are mutually exclusive, than the company should choose Project B since its NPV is greatrer.
Period 0 1 2 3 Project A -25 11 12 10 Project B -50 22.5 21.5 20.5 PVF @ 10% 1 0.909 0.826 0.751 Present Value Project A -25 9.999 9.912 7.510 Present Value Project B -50 20.453 17.759 15.396Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.