2. Bell Manufacturing is attempting to choose the better of two mutually exclusi
ID: 1170516 • Letter: 2
Question
2. Bell Manufacturing is attempting to choose the better of two mutually exclusive projects for expanding the firm's warehouse capacity. The relevant cash flows for the projects are shown in the following table. The firms cost of capital is 17%. Initial InvestmentProject X Project Y $280,000 $120,000 $120,000 $85,000 50,000 30,000 $500,000 Year (t) Cash Inflows $100,000 $160,000 $150,000 $210,000 $250,000 4 a. Calculate the IRR for each of the projects. Assess the acceptability of each project on the basis of the IRRs b. Which project is preferred?Explanation / Answer
IRR is the rate of return that makes NPV equal to 0
Project X:
-500,000 + 100,000 / ( 1 + R)1 + 160,000 / ( 1 + R)2 + 150,000 / ( 1 + R)3 + 210,000 / ( 1 + R)4 + 250,000 / ( 1 + R)5 = 0
After using trial and errod method i.e, after using various rates for R, let's try 18.65
-500,000 + 100,000 / ( 1 + 0.1865)1 + 160,000 / ( 1 + 0.1865)2 + 150,000 / ( 1 + 0.1865)3 + 210,000 / ( 1 + 0.1865)4 + 250,000 / ( 1 + 0.1865)5 = 0
0 = 0
Therefor IRR is 18.65%
Project Y:
-280,000 + 120,000 / ( 1 + R)1 + 120,000 / ( 1 + R)2 + 85,000 / ( 1 + R)3 + 50,000 / ( 1 + R)4 + 30,000 / ( 1 + R)5 = 0
After using trial and errod method i.e, after using various rates for R, let's try 17.71
0 = 0
Therefore IRR is 17.71%
Please note: It is always recommended to use a financial calculator to calculate IRR. trial and error method can be time consuming.
Basedon IRR project X should be accepted as it has a higher IRR
b)
NPV = present value of cash inflows - present value of cash outflows
NPV of project X = -500,000 + 100,000 / ( 1 + 0.17)1 + 160,000 / ( 1 + 0.17)2 + 150,000 / ( 1 + 0.17)3 + 210,000 / ( 1 + 0.17)4 + 250,000 / ( 1 + 0.17)5
NPV of project X = 22,102
NPV of project Y = -280,000 + 120,000 / ( 1 + 0.17)1 + 120,000 / ( 1 + 0.17)2 + 85,000 / ( 1 + 0.17)3 + 50,000 / ( 1 + 0.17)4 + 30,000 / ( 1 + 0.17)5
NPV of project Y = 3,663
Projet X has also a greater NPV, therefore project X is preferred.
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