Question

Dwight Donovan, the president of Baird Enterprises, is considering two investment opportunities. Because of limited resources, he will be able to invest in only one of them. Project A is to purchase a machine that will enable factory automation; the machine is expected to have a useful life of three years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $108,000 and for Project B are $45,000. The annual expected cash inflows are $42,666 for Project A and $18,736 for Project B. Both investments are expected to provide cash flow benefits for the next three years. Baird Enterprises’ cost of capital is 6 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Required

Compute the net present value of each project. Which project should be adopted based on the net present value approach?

Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach?

Answer 1

1. Net present value = Present value of cash inflow - initial investment

Project A = 42666*2.673-108000 = $6046

Project B = 18736*2.673-45000 = $5081

Project A should be adopted based on the net present value approach because it have more NPV.

2. Cumulative present value factor = Initial investment/ Annual cash inflow

Project A = 108000/42666 = 2.531

Internal rate of return Project A = 9%

Project B = 45000/18736 = 2.402

Internal rate of return Project B = 12%