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Horngren'S Financial And Managerial Accounting
Found in: Page 1474

Short Answer

Hayes Company is considering two capital investments. Both investments have an initial cost of $10,000,000 and total net cash inflows of $17,000,000 over 10 years. Hayes requires a 12% rate of return on this type of investment. Expected net cash inflows are as follows:

Year

Plan Alpha

Plan Beta

1

$ 1,700,000

$ 1,700,000

2

1,700,000

2,300,000

3

1,700,000

2,900,000

4

1,700,000

2,300,000

5

1,700,000

1,700,000

6

1,700,000

1,600,000

7

1,700,000

1,200,000

8

1,700,000

800,000

9

1,700,000

400,000

10

1,700,000

2,100,000

Total

$ 17,000,000

$ 17,000,000

Requirements

  1. Use Excel to compute the NPV and IRR of the two plans. Which plan, if any, should the company pursue?

  2. Explain the relationship between NPV and IRR. Based on this relationship and the company’s required rate of return, are your answers as expected in Requirement 1? Why or why not?

  3. After further negotiating, the company can now invest with an initial cost of $9,500,000 for both plans. Recalculate the NPV and IRR. Which plan, if any, should the company pursue?

Answer

  1. NPV for plans Alpha and Beta is 11% and 13%.

  2. Plan B should be pursued.

  3. Company HC should still pursue Plan B

See the step by step solution

Step by Step Solution

Step 1: Meaning of NPV

The approach to deciding project reasonability is called net present value (NPV). This approach decides the display value of cash inflows and outflows sometime recently, calculating the investment's net present value. On the off chance that a project's NPV is positive, it ought to be affirmed.

Step 2: Computing NPV and IRR

Plan

A

B

Inputs:

Useful life

10

10

Discount rate

12%

12%

Initial investment

$(10,000,000)

$(10,000,000)

Cash inflows

Year 1

1,700,000

1,700,000

Year 2

1,700,000

2,300,000

Year 3

1,700,000

2,900,000

Year 4

1,700,000

2,300,000

Year 5

1,700,000

1,700,000

Year 6

1,700,000

1,600,000

Year 7

1,700,000

1,200,000

Year 8

1,700,000

800,000

Year 9

1,700,000

400,000

Year 10

1,700,000

2,100,000

$17,000,000

$17,000,000

Outflows:

$(394,621)

$338,806

Net present value

11%

13%

It is concluded that the company would select project Beta from the above calculation as it has a positive NPV and IRR is more excellent than COC.

Step 3: Relationship between NPV and IRR

The net present value measures the net difference between the present value of the investment ‘s net cash flows and the investment’s cost, while the internal rate of return determines at what rate the net present value should equal zero.

Based on the calculated net present value and internal rate of return of Plans A and B, the company should pursue Plan B since it results in a positive net present value of $338,806, and its internal rate of return of $13 exceeded the required rate of return on 12%.

Step 4: Recalculating NPV and IRR


Plan

A

B

Inputs:

Useful life

10

10

Discount rate

12%

12%

Initial investment

$(9,500,000)

$(9,500,000)

Cash inflows

Year 1

1,700,000

1,700,000

Year 2

1,700,000

2,300,000

Year 3

1,700,000

2,900,000

Year 4

1,700,000

2,300,000

Year 5

1,700,000

1,700,000

Year 6

1,700,000

1,600,000

Year 7

1,700,000

1,200,000

Year 8

1,700,000

800,000

Year 9

1,700,000

400,000

Year 10

1,700,000

2,100,000

$17,000,000

$17,000,000

Outflows:

Net present value

$105,379

$ 838,806

Internal rate of return

12%

14%

Based on the calculated net present value and internal rate of return, Company HC should still pursue Plan B because it has a higher net present value amounting to $838,806 as compared to Plan A’s net present value amounting to $105,379.In addition, plan B‘s 14 % internal rate of return has exceeded the 12% required rate of return, compared to Plan A’s internal rate of return, which equals 12%.

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