You are given 2 choices and a budget of $50,000. Determine which you would choos

Question

You are given 2 choices and a budget of $50,000. Determine which you would choose using the below. WACC 9%

                              Choice 1(expansion)     Choice 2(efficiency)

Init. Inv.               50,000                               40,000  

Net OCF so no need to calculate anything-these are net

yr 1            15,000                             12,000

yr 2            25,000                             24,000

yr 3            20,000                             12,000

1. Choice 1 has a NPV and IRR of:

a. 10,000, 9.26%

b. 247, 9.26%

c. 595, 9.66%

d. (5000), 8.7%

2. Choice 2 has a NPV and IRR of:

a. 476, 9.66%

b. 8000, 9.66%

c. 2000, 9.66%

d. 0, 9.66%

3. Which would you choose and why (20 words or less)?

Explanation / Answer

Q.1. Choice 1 (expansion):-

NPV = P.V. Of Cash inflow - P.V. of Cash outflow

P.V. of cash inflow = 15000 * 0.917 + 25000 * 0.842 + 20000 * 0.772

= 50245

NPV = 50245 - 50000 =$ 245 (nearest to $ 247 given in options in the question)

Conclusion:- Choice 1 has a NPV and IRR of $ 247 and 9.26%. The option (b) is the right answer.

At IRR of 9.26 %, P.V. of cash inflow = P.V. of Cash outflow. (by Trial & Error method, taking any two rates 8% and 10%)

Q. 2. Choice 2(efficiency):-

   P.V. of Cash inflow = 12000 * 0.917 + 24000 * 0.842 + 12000 * 0.772

= $ 40476

P.V. of Cash Outflow = $ 40000

NPV = 40476 - 40000 = $ 476

   IRR may be calculated using Trial and Error Method. Take two rates 8% and 10%.

At 8%

P.V. of Cash inflow = 12000 * 0.926 + 24000 * 0.857 + 12000 * 0.794

=$ 41208

At 10%

P.V. of Cash inflow = 12000 * 0.909 + 24000 * 0.826 + 12000 * 0.751

= 39744

IRR = 8 + ( 10 - 8) * (41208 - 40000) / (41208 - 39744) ( By Interpolation)

= 8 + 2 * 1208 / 1464

= 8 + 2416 / 1464

= 8 + 1.66

= 9.66 %

Conclusion:- Choice 2 has a NPV and IRR of $ 476 and 9.66% respectively. The Right answer of Q.2 is (a).

Q.3. The Objective of Financial management is to maximize the wealth of the firm. So the NPV method is superior than IRR method. IRR provides a relative measure of value, whereas NPV provides an absolute measure. In Case of conflicts between the two, Annual NPV is calculated & the decision is based on NPV rule. So Choice 2 (Efficiency) is choosen having higher NPV than Choice 1 (Expansion).

Conclusion:- Choice 2 (Efficiency) is choosen having higher NPV than Choice 1 (Expansion)

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