Q33PGA
Expert-verifiedHayes 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
Use Excel to compute the NPV and IRR of the two plans. Which plan, if any, should the company pursue?
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?
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
NPV for plans Alpha and Beta is 11% and 13%.
Plan B should be pursued.
Company HC should still pursue Plan B
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.
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.
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%.
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%.
Hudson Manufacturing is considering three capital investment proposals. At this time, Hudson only has funds available to pursue one of the three investments.
| Equipment A | Equipment B | Equipment C |
Present value of net cash inflows | $1,647,351 | $1,969,888 | $2,064,830 |
Initial investment | (1,484,100) | (1,641,573) | (1,764,812) |
NPV | $163,251 | $328,315 | $300,018 |
Which investment should Hudson pursue at this time? Why?
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