Wheel has two other possible investment opportunities, which are mutually exclus
ID: 2717840 • Letter: W
Question
Wheel has two other possible investment opportunities, which are mutually exclusive, and independent of Investment A above. Both investments will cost $120,000 and have a life of 6 years. The after tax cash flows are expected to be the same over the six year life for both projects, and the probabilities for each year's after tax cash flow is given in the table below.
Investment B
Investment C
Probability
After Tax
Cash Flow
Probability
After Tax
Cash Flow
0.25
$20,000
0.30
$22,000
0.50
32,000
0.50
40,000
0.25
40,000
0.20
50,000
What is the expected value of each project’s annual after tax cash flow? Justify your answers and identify any conflicts between the IRR and the NPV and explain why these conflicts may occur.
Assuming that the appropriate discount rate for projects of this risk level is 8%, what is the risk-adjusted NPV for each project? Which project, if either, should be selected? Justify your conclusions.
Investment B
Investment C
Probability
After Tax
Cash Flow
Probability
After Tax
Cash Flow
0.25
$20,000
0.30
$22,000
0.50
32,000
0.50
40,000
0.25
40,000
0.20
50,000
Explanation / Answer
NPV is the difference between the present value of cash inflows and cash outflows. It can be calculated with the use of following formula:
NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Discount Rate)^1 + Cash Flow Year 2/(1+Discount Rate)^2 + Cash Flow Year 3/(1+Discount Rate)^3
__________
Step 1: Calculate Cash Flow for Each Year
Cash Flow Year 0 = Initial Investment = -$1,500,000
Annual After-Tax Flow (Year 1 to Year 3) = (Incremental Revenues - Incremental Costs - Depreciation)*(1-Tax Rate) + Depreciation
where Depreciation = Initial Investment/Life of the Project
Using the information provided, we get,
Annual After-Tax Flow (Year 1 to Year 3) = (1,200,000 - 600,000 - 1,500,000/3)*(1-35%) + 1,500,000/3 = $565,000
__________
Step 2: Calculate NPV
Using the values calcuated in Step 1 in the formula for NPV, we get,
NPV = -1,500,000 + 565,000/(1+6%)^1 + 565,000/(1+6%)^2 + 565,000/(1+6%)^3 = $10,251.75
Since, the NPV is positive, it is economically viable to accept the project.
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