Question

You are considering the following two mutually exclusive projects with the following cash flows:

              

                                                                  Project A                                  Project B

                                                            Year    Cash Flow                   Year    Cash Flow

                                                            0          -$75,000                         0       -$70,000

                                                            1          $19,000                         1       $10,000

                                                            2          $48,000                         2       $16,000

                                                            3          $12,000                         3       $72,000

       

               Required rate of return                     10 %                                        13 %

               

            Calculate the NPV, IRR, profitability index for each project. Which project will you choose? For each project, what do you observe about NPV, IRR, and profitability index? Do they lead you to the same decision?

Answer 1

NPV of A=-75000+19000/1.1+48000/1.1^2+12000/1.1^3=-$9,042.07

NPV of B=-70000+10000/1.13+16000/1.13^2+72000/1.13^3=$1,279.52

Profitability Index of A=1-9042.07/75000=0.88

Profitability Index of B=1+1279.52/70000=1.02

IRR of A:
-75000+19000/(1+IRR)+48000/(1+IRR)^2+12000/(1+IRR)^3=0
=>IRR=2.7634%

IRR of A:
-70000+10000/(1+IRR)+16000/(1+IRR)^2+72000/(1+IRR)^3=0
=>IRR=13.798%

Accept Project B
Yes all lead to the same decision as we accept projects whose NPV is positive or Profitability Index is more than 1 or IRR is more than the required rate of return