There are two projects: project A and project B. Each of the project has the cost of Rs 100,000 and cost of capital for each project is 12 percent. The project's expected net cash flows are as follows: Year Project A Project B 0 Rs (100,000) Rs (100,000) 1 65,000 35,000 2 30,000 30,000 3 30,000 30,000 4 10,000 10,000 a. Calculate NPV for each project. Which project or projects should be accepted if they are independent? b. Calculate IRR for each project. Which project should be accepted if they are mutually exclusive?
Question
There are two projects: project A and project B. Each of the project has the cost of Rs 100,000 and cost of capital for each project is 12 percent. The project's expected net cash flows are as follows: Year Project A Project B 0 Rs (100,000) Rs (100,000) 1 65,000 35,000 2 30,000 30,000 3 30,000 30,000 4 10,000 10,000 a. Calculate NPV for each project. Which project or projects should be accepted if they are independent? b. Calculate IRR for each project. Which project should be accepted if they are mutually exclusive?
Solution
a. The Net Present Value (NPV) is calculated by subtracting the initial investment from the present value of cash inflows. The present value of cash inflows is calculated by dividing each year's cash inflow by (1 + cost of capital) raised to the power of the year.
For Project A: NPV = -100,000 + 65,000/(1+0.12) + 30,000/(1+0.12)^2 + 30,000/(1+0.12)^3 + 10,000/(1+0.12)^4 NPV = -100,000 + 58,035 + 23,881 + 21,407 + 6,355 NPV = Rs 9,678
For Project B: NPV = -100,000 + 35,000/(1+0.12) + 30,000/(1+0.12)^2 + 30,000/(1+0.12)^3 + 10,000/(1+0.12)^4 NPV = -100,000 + 31,250 + 23,881 + 21,407 + 6,355 NPV = Rs -17,107
If the projects are independent, Project A should be accepted because it has a positive NPV.
b. The Internal Rate of Return (IRR) is the discount rate that makes the NPV of a project zero. It can be calculated using trial and error or a financial calculator.
For Project A, the IRR is approximately 18.5%. For Project B, the IRR is approximately 11.5%.
If the projects are mutually exclusive, Project A should be accepted because it has a higher IRR.
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