A company is examining two projects as a part of its expansion plan for the next
ID: 2752684 • Letter: A
Question
A company is examining two projects as a part of its expansion plan for the next year. Both projects are not mutually exclusive. The cost of Project A is $12,950 while Project B is expected to cost $18,625. The company's cost of capital (required rate of return) is 11.5 %. Expected annual cash flows are projected to be as follows:
Year
Project A
Project B
1
3,250.00
6,850.00
2
3,250.00
6,850.00
3
3,250.00
6,850.00
4
3,250.00
6,850.00
5
3,250.00
6,850.00
Each project will last an estimated 5 years with no remaining significant scrap value. Determine the IRR and the NPV for each of these two projects. What should Henn Corp decide about each proposed project.
Year
Project A
Project B
1
3,250.00
6,850.00
2
3,250.00
6,850.00
3
3,250.00
6,850.00
4
3,250.00
6,850.00
5
3,250.00
6,850.00
Explanation / Answer
Calculation of NPV
Net Present value = Present value of cash inflows less Initial cost
Present value factor at 11.50 % for 5 years = 3.64988
So net Present value =
Project A = (3250 * 3.64988) - 12950 = -1087.89 (negative NPV)
Project B = (6850 * 3.64988) - 18625 = 6376.68
Calculation IRR
We know that at IRR the present value of cash flows = present value of inflows
Project A outflows = 12950
Project A inflows = 3250 for 5 years
So when we discount 3250 for 5 years at 8.075% interest rate we get 3250 * 3.98483 = 12950
Therefore IRR for project A is 8.077 %
Project B cash inflows = 6850 for 5 years
intial outflow = 18625
So when we discount at 24.464% 6850 for 5 years we get 6850 * 2.71911 = 18625.
Therefore IRR for project B = 24.464%
Based on NPV method Hence Henn corp Should go for project B because it has positive NPV and project A is not viable as it has negative NPV.
Also based on IRR the Henn corp should go for Project B as IRR is more then required rate of return for project B and reject project A as project A has lower IRR as compared to required rate of return.
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