Question

Bruin, Inc., has identified the following two mutually exclusive projects: Year Cash Flow (A) Cash Flow (B) 0 –$ 37,500 –$ 37,500 1 17,300 5,700 2 16,200 12,900 3 13,800 16,300 4 7,600 27,500
1. What is the IRR for each of these projects? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
IRR
Project A %
Project B %
2. Using the IRR decision rule, which project should the company accept?
a. Project A
b. Project B
3. Is this decision necessarily correct?
a. Yes
b. No
4. If the required return is 11 percent, what is the NPV for each of these projects? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
a. NPV Project A
b. NPV Project B
5. Which project will the company choose if it applies the NPV decision rule?
a. Project A
b. Project B
5. At what discount rate would the company be indifferent between these two projects? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Answer:

Year             Cash Flow (A)            Cash Flow (B)

0                      -37,500                      -37,500

1                         17,300                         5,700

2                        16,200                       12,900

3                        13,800                       16,300

4                         7,600                       27,500

1) Using an excel spreadsheet and the IRR function:

IRR project A = 20%

IRR project B = 19%

2) Using the IRR decision rule, Bruin should choose project A.

3) In this case, since the length of the projects is only 4 years, then there should be no problem with the IRR decision rule, but for projects with longer time lengths, the discounts rates might vary and the best option is to use the modified internal rate of return (MIRR). But in this case the NPV of project B is higher, then Bruin should probably project B because it has a higher NPV. The NPV is always more important then the IRR.

4) Again using an excel spreadsheet and the NPV function:

NPV project A = $6,331

NPV project B = $8,139

5) first we must subtract cash flows from A by the  cash flows from B:

1      $11,600

2     $3,300

3    -$2,500

4   -$19,900

then we calculate the IRR = 16%

Bruin should be indifferent between the two projects at a 16% discount rate. That means that at discount rates above 16%, you should choose project A, but at discount rates below 16%, you should choose project B