A company is considering two investment alternatives described below. Using inte

Question

A company is considering two investment alternatives described below. Using internal rateof return, determine which project is recommended. The company only has capitalavailable to consider one alternative. The MARR for the agency has been set at 4%. Project A: Requires an initial investment of $1 million and begins generatingrevenue the first year at the rate of $150,000 per year. There is no value to the

investment at the end of 10 years. Project B: Requires an initial investment of $750,000 and generates $100,000per year beginning in the first year. There is no value to the investment at theend of 10 years.

1. Set up the equations for calculating the IRRs for each project. Estimate the IRR for eachproject using tables. (Don’t interpolate but provide upper and lower bounds).

2. IRR for project A is 8.14% and for project B is 5.6%. What do these values mean abouteach project individually?

3. To determine what project is preferred between project A and B an incremental IRRmust be calculated. Determine the incremental cash flow.

4. Set up the equation for calculating the Incremental IRR cash flow.

5. If the incremental IRR is 15.10%, which project is preferred? Be sure to clearly statedecision based on relationship of incremental IRR and MARR.

Explanation / Answer

Solution:

We need to compute the NPV of the projects

Hence the ProjectA NPV is :

Project B NPV's is :

IRR is something when the NPV is zero :

2) The IRR rate of the projects conveys that the minimum internal rate of the return of the project is 8.14% for project A and 5.6% for project B. This shows that any investors would expect the required rate of return to be so and so from the respectibve rpojects and only then they would gain profit.

3) to determine the incremental cashflow it is nothing but Project A - B becasue project A has higher cash flows and it is always the higher cash flows - the lesser cash flows :

NPV of the incremental cash flow :

Hence the Incremental IRR would be the rate at which the incremental NPv is zero

Since at 15.01% the NPV is zero hence the IRR is 15.01%

Year Cash flow Formula discount 4% Present value 0 -$1,000,000.00 $1.00 $1.00 -$1,000,000.00 1 $150,000.00 1/1.04^1 $0.96 $144,230.77 2 $150,000.00 1/1.04^2 $0.92 $144,230.77 3 $150,000.00 1/1.04^3 $0.89 $138,683.43 4 $150,000.00 1/1.04^4 $0.85 $133,349.45 5 $150,000.00 1/1.04^5 $0.82 $128,220.63 6 $150,000.00 1/1.04^6 $0.79 $123,289.07 7 $150,000.00 1/1.04^7 $0.76 $118,547.18 8 $150,000.00 1/1.04^8 $0.73 $113,987.67 9 $150,000.00 1/1.04^9 $0.70 $109,603.53 10 $150,000.00 1/1.04^10 $0.68 $105,388.01 Net present value $259,530.51

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