Question

You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $11.0 million. Investment A will generate $2.40 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $1.70 million at the end of the first year, and its revenues will grow at 3.2% per year for every year after that.

Which investment has the higher IRR ?

Which investment has the higher NPV when the cost of capital is 8.1% ?

Which investment should you select?

Select one:

a. Project B had the higher IRR, project A has the higher NPV. Select project A with the higher NPV. IRR can only be used to compare projects with equal initial investments.

b. Project A had the higher IRR, project B has the higher NPV. Select project B with the higher NPV. IRR can only be used to compare projects with equal initial investments.

c. Project A had the higher IRR, project B has the higher NPV. Select project A with the higher IRR. NPV can only be used to compare projects with equal initial investments.

d. Both projects are equally valuable. IRR and NPV are both reliable methods to compare projects' value.

Answer 1

a. IRR is the rate at which NPV = 0.

Investment A:

NPV = ( 2.40 / IRR ) - 11 = 0

IRR = 2.40 / 11 = 21.82 %

Investment B :

NPV = [1.70 / ( IRR - 0.032 ) ] - 11 = 0

IRR - 0.032 = 0.1545

IRR = 0.1865 or 18.65 %

Therefore, Investment A has the higher IRR.

b. NPV = Present Value of Cash Inflows - Initial Investment

Investment A :

NPV = ( 2.40 / 0.081 0 - 11 = $ 18.62963 million

Investment b :

NPV = [ 1.70 / ( 0.081 - 0.032 ) ] - 11 = $ 23.69388 million

Investment B has the higher NPV when the cost of capital is 8.1 %.

c. Answer:

b. Project A had the higher IRR, project B has the higher NPV. Select project B with the higher NPV. IRR can only be used to compare projects with equal initial investments.