A firm has a capital budget of $100 which must be spent on one of two projects, each requiring a present outlay of $100. Project A yields a return of $120 after one year, whereas Project B yields $201.14 after 5 years. Calculate: (i) the NPV of each project using a discount rate of 10%; (ii) the IRR of each project. What are the project rankings on the basis of these two investment decision rules? Suppose that you are told that the firm’s reinvestment rate is 12%, which project should the firm choose? Answer: (i)NPV(A) = 9.09; NPV(B) = 24.89, B>A (ii) IRR(A) = 20%; IRR(B) = 15%, A>B Using a reinvestment rate of 12% the terminal values are TV(A) = 188.82; TV(B) = 201.14, hence B>A. Alternatively calculate the IRR of (B-A): IRR(B-A) = 13.78% > 12%, hence undertake the “extra project” (B-A) ie. undertake B.
A firm has a capital budget of $100 which must be spent on one of two
projects, each requiring a present outlay of $100. Project A yields a return
of $120 after one year, whereas Project B yields $201.14 after 5 years.
Calculate:
(i) the NPV of each project using a discount rate of 10%;
(ii) the IRR of each project.
What are the project rankings on the basis of these two investment
decision rules? Suppose that you are told that the firm’s reinvestment
rate is 12%, which project should the firm choose?
Answer:
(i)NPV(A) = 9.09; NPV(B) = 24.89, B>A
(ii) IRR(A) = 20%; IRR(B) = 15%, A>B
Using a reinvestment rate of 12% the terminal values are TV(A) = 188.82; TV(B) = 201.14,
hence B>A. Alternatively calculate the IRR of (B-A): IRR(B-A) = 13.78% > 12%, hence
undertake the “extra project” (B-A) ie. undertake B.
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