question archive Dwight Donovan, the president of Rooney Enterprises, is considering two investment opportunities
Dwight Donovan, the president of Rooney Enterprises, is considering two investment opportunities
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Dwight Donovan, the president of Rooney Enterprises, is considering two investment opportunities. Because of limited resources, he will be able to invest in only one of them. Project A is to purchase a machine that will enable factory automation; the machine is expected to have a useful life of five years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $100,000 and for Project B are $32,000. The annual expected cash inflows are $33,438 for Project A and $9,321 for Project B. Both investments are expected to provide cash flow benefits for the next five years. Rooney Enterprises' desired rate of return is 6 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)
Required
- Compute the net present value of each project. Which project should be adopted based on the net present value approach?
- Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach?
Dwight Donovan, the president of Rooney Enterprises, is considering two investment opportunities. Because of limited resources, he will be able to invest in only one of them. Project A is to purchase a machine that will enable factory automation; the machine is expected to have a useful life of five years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are $100,000 and for Project B are $32,000. The annual expected cash inflows are $33,438 for Project A and $9,321 for Project B. Both investments are expected to provide cash flow benefits for the next five years. Rooney Enterprises' desired rate of return is 6 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)
Required
- Compute the net present value of each project. Which project should be adopted based on the net present value approach?
- Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach?
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Net present value calculation:
NPV for Project A = - 100000 + [33438 * PVFA (6%, 5 years)]
= - 100000 + (33438 * 4.21236)
= $ 40,853
NPV for Project B = - 32000 + [9321 * PVFA (6%, 5 years)]
= - 32000 + (9321 * 4.21236)
= $ 7,263.44
Project A should be chosen based on NPV approach as its NPV is higher.
Internal rate of return approach;
IRR is the discount rate that bring NPV of project's cash flows to 0. Thus:
IRR for project A
0 = - 100000 + (33438 / IRR) * [1 - (1 + IRR)^(- 5)]
or, IRR = 20%
IRR for project B
0 = - 32000 + (9321 / IRR) * [1 - (1 + IRR)^(- 5)]
or, IRR = 14%
Project A should be chosen based on IRR approach as its IRR is higher
