Question

A firm with a cost of capital of 10% is evaluating two independent projects utilizing the internal rate of return technique. Project X has an initial investment of $70,000 and cash inflows at the end of each of the next five years of $25,000. Project Z has an initial investment of $120,000 and cash inflows at the end of each of the next four years of $35,000. The firm should ________.

Answer 1

Answer:

The firm should invest in project X, which yields a net return of $30,000

Explanation:

To determine the project for which the company should invest in, we will calculate the net return (profit) from each investment, and choose the project with the greater profit.

Project Z:

initial investment = $120,000

cash inflow per year = $35,000

cash inflow for the next four years = 35,000 × 4 = $140,000

Net return on investment = 140,000 - 120,000 = 20,000.

Next, you will notice that for the project X, a period of 5 years was given, while for project Z,  a 4 year period was given. In order to effectively compare both projects, we will use the same time period, hence, calculating the net return on project X after 4 years:

Project X:

initial investment = $70,000

cash inflow per year = $25,000

cash inflow for the next 4 years = 25,000 × 4 = 100,000

Net return on investment = 100,000 - 70,000 = $30,000

since the net return on investment for project X is greater than that for project Z by $10,000, the firm should invest in project Z.