Question

Net Present Value Versus Internal Rate of Return

For discount factors use Exhibit 12B-1 and Exhibit 12B-2.

Skiba Company is thinking about two different modifications to its current manufacturing process. The after-tax cash flows associated with the two investments follow:

Year		Project I		Project II
0		$(100,000)		$(100,000)
1		—		63,857
2		134,560		63,857

Skiba's cost of capital is 12%.

Required:

1. Compute the NPV and the IRR for each investment. Round present value calculations and your final NPV answers to the nearest dollar. Round IRR answers to the nearest whole percent.

	NPV	IRR
Project I	$	%
Project II	$	%

2. Conceptual Connection: Explain why the project with the larger NPV is the correct choice for Skiba.

NPV is an measure and reveals how much the value of the firm will change for each project. IRR gives a measure of . Thus, since NPV reveals the total wealth change attributable to each project, it is preferred to the IRR measure.

Answer 1

1) Calculation of NPV

Project I

NPV = Present Value of Cash Outflows - Initial Investment

= [$134,560*PVF(12%, 2 yrs)] - $100,000

= ($134,560*0.79719) - $100,000

= $107,270 - $100,000 = $7,270

Therefore the NPV of Project I is $7,270.

Project II

NPV = Present Value of Cash Outflows - Initial Investment

= [$63,857*PVAF(12%, 2 yrs)] - $100,000

= ($63,857*1.69005) - $100,000

= $107,922 - $100,000 = $7,922

Therefore the NPV of Project II is $7,922.

Calculation of IRR

Project I

IRR is the rate at which present value of cash inflows is equal to present value of cash outflows or the rate at which NPV is zero. The IRR is calculated as follows:-

Initial Investment = Cash Inflow at the end of year 2*PVF(i%, 2 yrs) [where i = IRR]

$100,000 = $134,560*PVF(i%, 2 yrs)

PVF(i%, 2 yrs) = $100,000/$134,560

PVF(i%, 2 yrs) = 0.74316

From the present value table, the value of 0.74316 for 2 periods is at 16%. Therefore the IRR for Project I is 16%.

Project II

Initial Investment = Annual Cash Inflows*PVAF(i%, 2 yrs) [where i = IRR]

$100,000 = $63,857*PVAF(i%, 2 yrs)

PVAF(i%, 2 yrs) = $100,000/$63,857

PVAF(i%, 2 yrs) = 1.5660

From the present value annuity table, the value of 1.5660 for 2 periods is at 18% (approx). Therefore the IRR for Project II is 18%.

	NPV	IRR
Project I	$7,270	16%
Project II	$7,922	18%

2) NPV is an measure of profitability of a project or investment which is calculated as the difference between present value of cash inflows and cash outflows. It reveals how much the value of the firm will change for each project. IRR is the discount rate that makes the net present value (NPV ) of all cash flows from a particular project equal to zero. Thus, since NPV reveals the total wealth change attributable to each project, it is preferred to the IRR measure.