Question

1. Mr. Oriento of Zed Ltd. Has to make a choice between two mutually exclusive investments:        

           

Cash flows (Shs. ‘000’)
	T0	T1	T2	IRR
Alpha	-400	250	300	23
Omega	200	140	179	36

The opportunity cost of capital is 9% per annum. Mr. Oriento wants to invest in Omega which has the higher IRR.

Do you agree with Mr. Oriento’s choice?   Show appropriate computations. (5 marks

Answer 1

We need to perform incremental analysis between the given options

Incremental cash flow at T0 (Alpha - omega) = -400 - (-200) = -200

Incremental cash flow at T1 (Alpha - omega) = 250 - 140 = 110

Incremental cash flow at T2 (Alpha - omega) = 300 - 179 = 121

Let incremental IRR be i%, then

-200 + 110*(P/A,i%,2) + (121-110)*(P/F,i%,2) = 0

110*(P/A,i%,2) + 11*(P/F,i%,2) = 200

using trail and error method

When i = 9%, value of 110*(P/A,i%,2) + 11*(P/F,i%,2) = 110* 1.759111 + 11* 0.841680 = 202.7607

When i = 10%, value of 110*(P/A,i%,2) + 11*(P/F,i%,2) = 110* 1.735537 + 11* 0.826446 = 200

Therefore incremental IRR = 10%

As incremental IRR > MARR (9%), Alpha option must be selected