Question

Dwight Donovan, the president of Benson 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 $104,000 and for Project B are $39,000. The annual expected cash inflows are $49,371 for Project A and $16,799 for Project B. Both investments are expected to provide cash flow benefits for the next three years. Benson Enterprises’ cost of capital is 8 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

NPV -
Present value of Cash inflow - Present value of cash outflow(i.e. Initial investment)

Both has positive NPV, both can be adopted but Project A is prefered due to higher value in NPV

Internal Rate of Return -
The Discounting rate at which Total Discounted Cash Inflow equals Initial Investment

Accept/Reject Criterion
IRR > Cost of Capital: Accept
IRR < Cost of Capital: Reject
IRR = Cost of Capital: Indifferent

In above case both of project IRR is greater than 8%. So, based on the internal rate of return approach any one can be adopted but Project A will return higher in value so it is prefered.