Question

The management of Lefty Company is considering the purchase of one of two machines (investment projects) with related information given in the table below.

The company’s cost of capital (required rate of return) is 10%

	Amount of Investment	NPV of the investment
Machine A	$120,000	$12,000
Machine B	$150,000	$13,500

Which one of the following statements is correct (true)?

• If the residual value used in the calculation of the NPV of Machine A was $5,000, but was then increased to $7,000, the NPV of the investment proposal would be less than $12,000 (with all other information used in the calculation remaining the same).

• If the decision rule used in choosing between the two investments is the “project profitability” index the company would choose to purchase Machine B.

• The internal rate of return (IRR) on both Machine A and Machine B must be greater than 10%.

• The project profitability index for Machine B is 11.1

Answer 1

As the NPV of both the investment is positive, the internal rate of return (IRR) on both Machine A and Machine B must be greater than 10%.

Internal rate of return (IRR) is the rate at which NPV of an investment is zero. A positive NPV indicates that IRR must be greater than required rate of return of 10%.

Option C is correct

	Machine A	Machine B
NPV of the investment	12000	13500
Divide by Amount of Investment	120000	150000
Project profitability index	0.10	0.09
The company would choose to purchase Machine A based on project profitability index