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Horngren'S Financial And Managerial Accounting
Found in: Page 1475

Short Answer

Hamilton Company is considering two capital investments. Both investments have an initial cost of $7,000,000 and total net cash inflows of $16,000,000 over 10 years. Hamilton requires a 20% rate of return on this type of investment. Expected net cash inflows are as follows:

Year

Plan Alpha

Plan Beta

1

$1,600,000

$1,600,000

2

$1,600,000

2,200,000

3

$1,600,000

2,800,000

4

$1,600,000

2,200,000

5

$1,600,000

1,600,000

6

$1,600,000

1,500,000

7

$1,600,000

1,300,000

8

$1,600,000

1,100,000

9

$1,600,000

900,000

10

$1,600,000

800,000

Total

$16,000,000

$16,000,000

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 $6,500,000. Recalculate the NPV and IRR. Which plan, if any, should the company pursue?

1. The company should pursue plan Beta with a positive NPV.

Plan Alpha

Plan Beta

NPV

($292,044.66)

$610,050.83

IRR

18.76%

22.89%

2. NPV and IRR have direct relation.

3. When the initial investment declines to $6,500,000, plan beta must be selected because of higher NPV and IRR.

Plan Alpha

Plan Beta

NPV

$207,955.34

$1,110,050.83

IRR

20.94%

25.59%

See the step by step solution

Step by Step Solution

Step 1: Definition of Internal Rate of Return

The internal rate of return is the metric used in capital budgeting to determine the project’s profitability. IRR is calculated using the same formula as used for NPV. Under calculation of IRR net present value is considered as 0.

Step 2: Calculation of NPV and IRR using excel

Project

Plan Alpha

Plan Beta

Useful life

10

10

Discount rate

0.2

0.2

Initial investment

-7000000

-7000000

1

1600000

1600000

2

1600000

2200000

3

1600000

2800000

4

1600000

2200000

5

1600000

1600000

6

1600000

1500000

7

1600000

1300000

8

1600000

1100000

9

1600000

900000

10

1600000

800000

Total

16,000,000

16000000

Outputs

NPV

($292,044.66)

$610,050.83

IRR

18.76%

22.89%

Excel formula for NPV: =NPV(Discount rate, Cash flow from 1st year to 10th year)+Initial investment

Excel formula for IRR: =IRR(All cash flows from year 1st year to 10th year including initial investment)

Step 3: Relationship between IRR and NPV

It can be said that the IRR and NPV have a direct relationship with each other. So, the higher the NPV higher the IRR, and the lower the NPV, the lower the IRR. The results of requirement 1 are not as expected because the net present value of plan A is negative, and its IRR is still higher than plan B. It is so because the negative value of the NPV is higher than the positive value of the NPV.

Step 4: When the initial investment is $6,500,000

Project

Plan Alpha

Plan Beta

Useful life

10

10

Discount rate

0.2

0.2

Initial investment

-6500000

-6500000

1

1600000

1600000

2

1600000

2200000

3

1600000

2800000

4

1600000

2200000

5

1600000

1600000

6

1600000

1500000

7

1600000

1300000

8

1600000

1100000

9

1600000

900000

10

1600000

800000

Total

16,000,000

16000000

Outputs

NPV

$207,955.34

$1,110,050.83

IRR

20.94%

25.59%

Excel formula for NPV: =NPV(Discount rate, Cash flow from 1st year to 10th year)+Initial investment

Excel formula for IRR: =IRR(All cash flows from year 1st year to 10th year including initial investment)

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