1-Projects 1 and 2 have similar outlays, although the patterns of future cash fl
ID: 2742662 • Letter: 1
Question
1-Projects 1 and 2 have similar outlays, although the patterns of future cash flows are different. The cash flows as well as the NPV and IRR for the two projects are shown below. For both projects, the required rate of return is 10 percent and there is no capital rationing.
Project 1 Project 2
0 -50 -50
1 20 0
2 20 0
3 20 0
4 20 100
NPV 13.40 18.30%
IRR 21.86% 18.92%
a) If the two projects are mutually exclusive what is the appropriate decision and by how much the company’s value will increase? b) If the two projects are independent what is the appropriate decision and by how much the company’s value will increase?
b) If the two projects are independent what is the appropriate decision and by how much the company’s value will increase?
Explanation / Answer
a) If the two projects are mutually exclusive, The investment project which has high NPV and high IRR is accepted. In this question, Project 2 has higher NPV than the Project 1 wheras Project 1 has higher IRR than the Project 2. Thus, here arises conflict between NPV and IRR.
In case of conflict between NPV and IRR, the decision regarding the selection of investment project is to be taken on the basis of NPV because IRR measures only the quality of investment while NPV takes into account both quality and the scale of investment. The objective of financial management is to maximize the wealth of the firm. So the NPV method is superior than IRR method. The project which have high annual NPV is selected. Thus, Project 2 is to be selected.
Conclusion:- The appropriate decision is to select Project 2.
b) If the two projects are independent, then all those investment projects will be selected which have Positive or Zero NPV. Accordingly, Project 1 as well as Project 2 both are selected if these projects are independent.
Conclusion:- The appropriate decision is to select both the projects i.e., Project 1 as well as Project 2.
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