NPV AND OTHER INVESTMENT CRITERIA
- APPLICATIONS -
1. Black Sea Recreation Company
a) Project Deepwater Fishing (A):
|
Year |
Discounted CF |
Cumulative CF |
Discounted payback period for project A = 2 + $301,701/591,765 = 2.51 years
Project New Submarine Ride (B):
|
Year |
Discounted CF |
Cumulative CF |
Discounted payback period for project B = 2 + $1,203,402/1,775,294 = 2.68 years
Therefore, project A should be chosen.
b) IRR of project A = 24.30%; IRR of project B = 21.46%
Based on the IRR rule, project A should be chosen, since it has a greater IRR.
c) Incremental IRR:
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Year | ||||
|
B-A |
Incremental IRR = 19.92%
Since the incremental IRR is greater than the required rate of return, 15%, choose project B.
d) NPV(A) = $290,063.29; NPV(B) = $571,891.18
Since NPV(B) is higher than NPV(A), choose project B.
Yes, the NPV rule is consistent with the incremental IRR rule.
2. WachLiszt, Inc.
a) PIproject 1 = 3.54; PIproject 2 = 4.37 ; PIproject 3 = 2.65
All should be chosen, since PI is higher than 1.
b) Subject to the budget constraints either project 1+3 or 2+3.
Project 1+3 would create the highest value per dollar invested (see NPVs).
c) In this case, projects 1 and 2 would be selected.
d) PIproject 1 = 3.369; PIproject 2 = 4.171 ; PIproject 3 = 2.493.
Same as in b).
3.
a) IRR(A) = 25.69%; IRR(B) = 19.43%
b) You would choose project A because of the higher IRR
c) The difference in scale between the two projects was ignored.
d) The problem can be remedied by using the incremental IRR method.
e) First, compute the incremental cash flows of (B-A):
|
C0 |
C1 |
C2 |
|
|
B-A |
On these cash flows we compute incremental IRR = 19.09%
f) If the discount rate is less than 19.19%, choose project B. Otherwise, choose project A, but not for discount rates higher than 25.69% (IRR for project A).
g) At 15%, we compute the NPVs of both projects:
NPV(A) = $2,069.64
NPV(B) = 17,013.24
4. Westbury Manufacturing
a) The computation of NPVs is to be found below:
|
Discount rate |
NPV |
b) 0 = - 1,600 + 10,000/(1+IRR)-10,000/(1+IRR)2
1 / (1+IRR) = x
0 = - 1,600 + 10,000 x - 10,000 · x2
- 100 · x2 x - 16 = 0
Δ = b2 - 4ac = 1002 - 4
= 10,000 - 6,400 = 3,600
x1,2 = -b ± √∆ / 2a = - 100 ± 60 / - 200 x1 = 0.2 IRR = 400%
x2 IRR = 25%
The
2 IRRs are 25% and 400%
the ones for which NPVs are zero.
c) Look at the NPV profile.
At an OCC of 450% Westbury should not accept this project, because its NPV is negative (=-112.40); but the project can be accepted at an OCC of 200%, because NPV is positive (=622.22).
5. Ruckhouser Corp.
a) The NPVs for the projects are as follows:
Project A = $10,765
Project B = -$10,898
Project C = $2,585
Project D = -$4,789
Project E = -$13,974.
Only projects A and C have positive NPVs.
The others are really "financing" projects and should not be selected, as the cost of borrowing (IRR) is higher than the opportunity cost of capital.
b) If the projects were mutually exclusive, one would select project A, as it has the highest NPV.
6. Pension fund
Although the profitability index is higher for project B than for project A, the NPV is the increase in the value of the company that will occur if a particular project is undertaken.
Thus, the project with the higher NPV should be chosen because it increases the value of the firm at most.
Only in the case of capital rationing could the pension fund manager be correct.
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