Wheel has two other possible investment opportunities, which are mutually exclus

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 G.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. H.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.

Explanation / Answer

Part G)

The expected after-tax cash flow can be calculated with the use of following formula:

Expected After-Tax Cash Flow = Sum of (Probability*After-Tax Cash Flows)

________

Using the values provided in the question, we get,

Expected After-Tax Cash Flow (Investment B) = .25*20,000 + .50*32,000 + .25*40,000 = $31,000

Expected After-Tax Cash Flow (Investment C) = .30*22,000 + .50*40,000 + .20*50,000 = $36,600

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IRR is the minimum acceptable rate of return at which NPV = 0. The IRR can be calculated with the use of IRR function of EXCEL. The basic formula for calculating IRR is given below:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 3/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3 + Cash Flow Year 4/(1+IRR)^4 + Cash Flow Year 5/(1+IRR)^5 + Cash Flow Year 6/(1+IRR)^6

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IRR has been calculated with the use of EXCEL as follows:

IRR (Investment B) = 14.17%

IRR (Investment C) = 20.57%

To calculate NPV, we need to have the WACC/Discount Rate (which is not provided in the question, for answering this part). However, the conflict may occur, if the IRR of a particular project/investment is higher than that of other one (assuming 2 projects/investments), while the NPV of the same project/investment is lower than that of the other one. In such a case, it may result in a conflict as to which the project should be chosen, the one with higher NPV or the one with higher IRR. Such a situation arises in case of mutually exclusive projects.

In case of such a conflict, it is always preferable to use NPV as the basis for the selection of the projects.

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Part H)

NPV is the difference between the present value of cash inflows and cash outflows. The formula for calculating NPV is given below:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Discount Rate)^1 + Cash Flow Year 3/(1+Discount Rate)^2 + Cash Flow Year 3/(1+Discount Rate)^3 + Cash Flow Year 4/(1+Discount Rate)^4 + Cash Flow Year 5/(1+Discount Rate)^5 + Cash Flow Year 6/(1+Discount Rate)^6

________

NPV (Investment B) = -120,000 + 31,000/(1+8%)^1 + 31,000/(1+8%)^2 + 31,000/(1+8%)^3 + 31,000/(1+8%)^4 + 31,000/(1+8%)^5 + 31,000/(1+8%)^6 = $23,309.27

NPV (Investment C) = -120,000 + 36,600/(1+8%)^1 + 36,600/(1+8%)^2 + 36,600/(1+8%)^3 + 36,600/(1+8%)^4 + 36,600/(1+8%)^5 + 36,600/(1+8%)^6 = $49,197.40

Since, both the investments provide a positive NPV, Investment C should be accepted (as it provides higher NPV), if there is a budget constraint and the investments are mutually exclusive.

Cash Flow Year Investment B Investment C 0 -120,000 -120,000 1 31,000 36,600 2 31,000 36,600 3 31,000 36,600 4 31,000 36,600 5 31,000 36,600 6 31,000 36,600 IRR =IRR(-120000,31000,31000,31000,31000,31000,31000)= 14.17% =IRR(-120000,36600.36600,36600,36600,36600,36600) 20.57%

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