Consider the following projects, A and B where the firm can only choose one. Pro
ID: 2771792 • Letter: C
Question
Consider the following projects, A and B where the firm can only choose one. Project A costs $30 and has cash flows of $5, 10, 15, 20 in each of the next four years. Project B also costs $30, and generates cash flows of $20, 10, 8, 6 for the next four years, respectively. WACC is 10 percent. A) Draw the timelines for both projects: A and B. B) Calculate the projects’ NPVs, IRRs, payback periods. C) If the two projects are independent, which project(s) should be chosen? D) If the two projects are mutually exclusive, which projects should be chosen? E) Plot NPV profiles for the two projects ( using Excel). Identify the projects’ IRRs on the graph. F) If the WACC were 5 percent, would this change your recommendation if the projects were mutually exclusive? If the WACC were 15 percent, would this change your recommendation? Explain your answers. G) There is a “crossover rate” of A’s and B’s NPV curves, and mark it on the graph with Point O (Hint: 13.53%). Explain in words what this rate is and how it affects the choice between mutually exclusive projects. H) If it possible for conflicts to exist between the NPV and the IRR when independent projects are being evaluated? Explain your answer.
Explanation / Answer
Solution:
Project A NPV Year 0 Year 1 Year 2 Year 3 Year 4 Initial Investment -30 Cash inflows 5 10 15 20 Present value of $ 1 @ 10 % 1 0.909 0.826 0.751 0.683 Present value of cash flows -30 4.55 8.26 11.27 13.66 Total present value of cashflows 37.74 NPV = Total present value of cashflows -Initial investment 7.74 IRR NPV @ 20 % Year 0 Year 1 Year 2 Year 3 Year 4 Initial Investment -30 Cash inflows 5 10 15 20 Present value of $ 1 @ 20 % 1 0.833 0.694 0.579 0.482 Present value of cash flows -30 4.17 6.94 8.68 9.65 Total present value of cashflows 29.44 NPV = Total present value of cashflows -Initial investment - 0.56 IRR = 10 % + (-0.56/7.74+0.56)*10 =%10.67% Pay Back Period Year Cash Flow Cumulative Cashflow 0 -30 -30 1 5 -25 2 10 -15 3 15 0 4 20 20 Pay Back Period 3 years