Question

BHC Inc. has invested in a gold mining operation that costs $75 million with an expected life of 5 years. In the first two years, the project generates an annual cash inflow of $120 million. In the third year, BHC Inc. needs to consider extensive environmental and site restoration generating a cash outflow of $100 million for that year. In the final two years of the operation, cash inflows of $135 million and $150 million are generated respectively. Which of the following answers best applies to this project?

Select one:

a. BHC Inc.’s cash flows are non-conventional, and hence the NPV and IRR capital budgeting methods will give the same decision.

b. BHC Inc.’s cash flows are conventional, and hence the NPV and IRR capital budgeting methods may conflict. If in doubt, use the NPV method.

c. BHC Inc.’s cash flows are conventional, and hence the NPV and IRR capital budgeting methods will give the same decision.

d. BHC Inc.’s cash flows are non-conventional, and hence the NPV and IRR capital budgeting methods may conflict. If in doubt, use the NPV method.

Answer 1

Conventional cash flows are those in which there is an initial outlay of cash and after that there are only cash inflows.

Non-conventional cash flows are those in which there is inflow and outflow throughout the life of project.

In this project since we have cash outflow twice (once at the beginning and once in third year) this means they are non-conventional cash flows. Whenever there are non-conventional cash flows IRR gives multiple values.

NPV on the other hand always gives one value.

Thus, NPV and IRR may differ and if in doubt NPV is a better method to decide.

Based on the explanation above option D is the right answer.

P.S. : although the question has numerical data given, No numerical calculation is required to arrive at the answer.