PRODLEVMS 11-7 CAPITAL BUDGETING CRITERIA A firm with a 14% WACC is evaluating t

Question

PRODLEVMS 11-7 CAPITAL BUDGETING CRITERIA A firm with a 14% WACC is evaluating two projects for this year's capital budget. After-tax cash flows, including depreciation, are as follows: 0 4 Project A$6,000 $2,000 $2,000 $2,000 2,000 2,000 Project B -$18,000 5,600 $5,600 $5,600 $5,600 $5,600 a. b. c. d. Calculate NPV and IRR for each project. Assuming the projects are independent, which one(s) would you recommend? If the projects are mutually exclusive, which would you recommend? Notice that the projects have the same cash flow timing pattern. Why is there a conflict between NPV and IRR?

Explanation / Answer

Project A

Statement showing NPV

IRR is the rate where NPV is 0 At 19.86% NPV comes to 0 hence IRR = 19.86%

Project B)

Statement showing NPV

IRR = At 16.8% NPV comes to zero hence IRR = 16.8%

B) Projects are independent means acceptance of one project will not affect acceptance of 2nd project, Thus we should select project A and project B both as their NPV is positive

C) If project are mutually exclusive we should select project B as it has higher NPV ( Project are mutually exclusive means only one of them can be taken up)

D) Both NPV and IRR are capital bugeting tools however difference is in their methodology. NPV formula solves for present value of stream of cash flow, given a discount rate while IRR on other hand solves for rate of return, taking NPV as Zero. NPV is absolute measure and on other hand IRR is relative measure. Thus if we see as per IRR project A looks attractive while as per NPV project B looks attractive. This conflict arisies only in case of mutually exclusive projects. However NPV is considered as better option because of falsy assumption of IRR that the cash generated from investment project are re invested at IRR

Particulars 1 2 3 4 5 Total Cash flow 2000 2000 2000 2000 2000 PVIF @ 14% 0.877193 0.769468 0.674972 0.59208 0.519369 PV 1754.386 1538.935 1349.943 1184.161 1038.737 6866.162 Less initial investment 6000 NPV 866.1619

Related Questions

Navigate

• Browse (All)
• Browse P
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.