Dwight Donovan, the president of Fanning Enterprises, is considering two investm

ID: 2530424 • Letter: D

Question

Dwight Donovan, the president of Fanning Enterprises, is considering two investment opportunities. Because of limited resources, he will be able to invest in only one of them. Project A is to purchase a machine that will enable factory automation; the machine is expected to have a useful life of five years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $116,000 and for Project B are $32,000. The annual expected cash inflows are $38,788 for Project A and $9,321 for Project B. Both investments are expected to provide cash flow benefits for the next five years. Fanning Enterprises’ cost of capital is 8 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Required

Compute the net present value of each project. Which project should be adopted based on the net present value approach?

Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach?

Explanation / Answer

Solution:-

Particulars

Project A

Project B

(a)Initial expenditure

116000

32000

(b)PV of cash inflow

(38788*3.9927) = 154868.85

(9321*3.9927) =37215.96

Net benefit (b-a)

38868.85

5215.96

PVAF for 5 yrs @ 8% = 3.9927

Project A provides higher benefit

2.IRR approach

Project A:-

PV of cash outflow = PV of cash inflow

116000 = 38788* PVAF

PVAF = 2.9906

Rate of return = 20%

Project B:-

PV of cash outflow = PV of cash inflow

32000 = 9321* PVAF

PVAF = 3.433

Rate of return = 14%