Thompson Manufacturing is considering two investment proposals. The first involv

Question

Thompson Manufacturing is considering two investment proposals. The first involves a quality improvement project, and the second is about an advertising campaign. The cash flows associated with each project appear below:

Suppose the hurdle rate of the firm is 10%. Calculate the cash flows of the “incremental project” by subtracting the cash flows of the second project from the cash flows of the first project. What is the IRR of the incremental project?

Quality Improvement Advertising Campaign Initial Cash Outflow $100,000 $100,000 Cash Flows Year 1 $10,000 $80,000 Year 2 $30,000 $45,000 Year 3 $125,000 $10,000

Explanation / Answer

NPV at 10% Increamental Project Cash Flows Discount Net Cash Flows 0 1 0 -70000 0.909090909 -63636.4 -15000 0.826446281 -12396.7 115000 0.751314801 86401.2 NPV 10368.14 NPV at 20% 1 Increamental Project Cash Flows Discount Net Cash Flows 0 1 0 -70000 0.833333333 -58333.3 -15000 0.694444444 -10416.7 115000 0.578703704 66550.93 NPV -2199.07 IRR = Lower Rate+ NPV at lower rate/ NPV at lower rate+ NPV at higher Rate ( HR-LR) IRR = 10+ 10368/10368+2200(20-10) IRR = 10+8.2 IRR = 18.2% Internal Rate of Return for the Increamental Project is 18.2%

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