You are considering two independent projects. Project A has an initial cost of $

Question

You are considering two independent projects. Project A has an initial cost of $125,000 and cash inflows of $46,000, $79,000, and $51,000 for years 1 to 3, respectively. Project B costs $135,000 with expected cash inflows for years 1 to 3 of $50,000, $30,000, and $100,000, respectively. The required return for both projects is 16 percent. Based on IRR, you should: O Accept both projects. O Accept Project A and reject Project B. O Accept Project B and reject Project A. O Reject both projects. O Accept either one of the projects, but not both

Explanation / Answer

Answer to Question 1:

Project A:

Let IRR be i%

NPV = -$125,000 + $46,000/(1+i) + $79,000/(1+i)^2 + $51,000/(1+i)^3
0 = -$125,000 + $46,000/(1+i) + $79,000/(1+i)^2 + $51,000/(1+i)^3

Using financial calculator, i = 18.86%

IRR for Project A = 18.86%

Project B:

Let IRR be i%

NPV = -$135,000 + $50,000/(1+i) + $30,000/(1+i)^2 + $100,000/(1+i)^3
0 = -$135,000 + $50,000/(1+i) + $30,000/(1+i)^2 + $100,000/(1+i)^3

Using financial calculator, i = 13.78%

IRR for Project B = 13.78%

IRR for Project A is higher than the required rate of return but IRR for Project B is lower than the required rate of return.

Accept Project A and reject Project B.

Answer to Question 2:

Change in retained earnings = Net income - Dividends
$14,308 = Net income - $3,200
Net income = $17,508

Net income = (Sales - Cost of goods sold - Interest - Depreciation) * (1 - tax)
$17,508 = (Sales - $92,511 - $4,608 - $18,709) * (1 - 0.35)
$17,508 = (Sales - $115,828) * 0.65
$26,935 = Sales - $115,828
Sales = $142,763

Tax = (Sales - Cost of goods sold - Interest - Depreciation) * tax rate
Tax = ($142,763 - $92,511 - $4,608 - $18,709) * 0.35
Tax = $9,427

EBIT = Sales - Cost of goods sold - Depreciation
EBIT = $142,763 - $92,511 - $18,709
EBIT = $31,543

Operating Cash Flow = EBIT - Tax + Depreciation
Operating Cash Flow = $31,543 - $9,427 + $18,709
Operating Cash Flow = $40,825.00

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