You have two projects with the following cash flows. You can choose only one of
ID: 2654601 • Letter: Y
Question
You have two projects with the following cash flows. You can choose only one of the projects. Your financial software gives you the following information. You are very tempted to select projects based on IRR which you recall to be a return. Obviously, you would think of choosing project B.
Year, t
A, $m
B, $m
0
-1,000
-500
1
100
400
2
200
350
3
500
250
4
700
100
5
800
50
IRR, %
25.46
53.88
NPV (8%)
NPV (20%)
Yet, you remember from your MBA classes that NPV is important and sometimes there could be conflicts in selection between this measure and the others.
You also remember that you could determine that with the help of a graph. Your task then is:
1.Draw the graph in question (as an approximation) and decide which project to take if your cost of capital is 8%. How about if your firm’s cost of capital is 20%?
2.Verify your assessment by computing the NPV for these two costs of capital
3.Explain why IRR and NPV could give you conflicting information—focus on the size and timing of cash flows.
Year, t
A, $m
B, $m
0
-1,000
-500
1
100
400
2
200
350
3
500
250
4
700
100
5
800
50
IRR, %
25.46
53.88
NPV (8%)
NPV (20%)
Explanation / Answer
2.NPV at 8%
t
A
B
PV factor 8%
PV A
PV B
0
-1000
-500
1.000
-1000.00
-500.00
1
100
400
0.926
92.59
370.37
2
200
350
0.857
171.47
300.07
3
500
250
0.794
396.92
198.46
4
700
100
0.735
514.52
73.50
5
800
50
0.681
544.47
34.03
NPV
719.96
476.43
At 8% cost of capital, Project A has higher NP. Therefore project A should be selected.
NPV at 20%
t
A
B
PV factor 20%
PV A
PV B
0
-1000
-500
1.000
-1000.00
-500.00
1
100
400
0.833
83.33
333.33
2
200
350
0.694
138.89
243.06
3
500
250
0.579
289.35
144.68
4
700
100
0.482
337.58
48.23
5
800
50
0.402
321.50
20.09
NPV
170.65
289.38
At 20% cost of capital, Project B has higher NP. Therefore project B should be selected.
If the high amount of cash flows is in the initial phase of the project, it may have a very high amount of irr.
t
A
B
PV factor 8%
PV A
PV B
0
-1000
-500
1.000
-1000.00
-500.00
1
100
400
0.926
92.59
370.37
2
200
350
0.857
171.47
300.07
3
500
250
0.794
396.92
198.46
4
700
100
0.735
514.52
73.50
5
800
50
0.681
544.47
34.03
NPV
719.96
476.43
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