The Finance Director of Ritoria Ltd thinks that the project with the higher NPV should be chosen whereas its Managing Director thinks that the one with the higher IRR should be undertaken
Posted by Satish Raj Pathak at 2:01 AM
The Finance Director of Ritoria Ltd thinks that the project with the higher NPV should be chosen whereas its Managing Director thinks that the one with the higher IRR should be undertaken, especially as both projects have the same initial outlay and length of life. The company anticipates a cost of capital of 10% and the net after tax
cash flows of the projects are as follows:
<!--[if !vml]--> <!--[endif]--> Year 0 1 2 3 4 5
<!--[if !vml]--><!--[endif]--> (Cash Flows figs 000)
Project X Rs. (200) 35 80 90 75 20
Project Y Rs. (200) 218 10 10 4 3
<!--[if !vml]--><!--[endif]-->
You are required to :
1. Calculate the NPV and IRR of each project.
2. State, with reasons, which of the two mutually exclusive projects you would recommend.
3. Explain the reasons for inconsistency in the ranking of the two projects.
Solution: BY NPV METHOD:
NPV is the sum of all terms <!--[if !vml]--><!--[endif]-->,
-200/(1.1)=-200
35/1.1=31.82
80/1.21=66.21
90/1.331=67.62
75/1.4641=51.23
20/1.61051=12.42 here 200-all 5 above
200-229.21= -29.21 for x
For y:
-200/1.1=-200
218/1.1=198.18
10/1.21=8.26
10/1.331=7.51
4/1.4641=2.73
3/1.61051=1.86
Here 200- all 5 above
200-218.54 = -18.54
BY IRR METHOD:
rate of return is given by r in:
<!--[if !vml]--><!--[endif]-->
-200+31.82+66.12+67.62+51.23+12.42 = 29.3 for x
-200+198.18+8.26+7.51+2.73+1.86 = 18.54 for y
Using IRR and NPV,then what are the reasons for the inconsistency of the rankings of the two project?
The Finance Director of Ritoria Ltd thinks that the project with the higher NPV should be chosen whereas its Managing Director thinks that the one with the higher IRR should be undertaken, especially as both projects have the same initial outlay and length of life. The company anticipates a cost of capital of 10% and the net after tax cash flows of the projects are as follows:
Year 0 1 2 3 4 5
(Cash Flows figs 000)
Project X Rs. (200) 35 80 90 75 20
Project Y Rs. (200) 218 10 10 4 3
You are required to :
a. Calculate the NPV and IRR of each project.
b. State, with reasons, which of the two mutually exclusive projects you would recommend.
c. Explain the reasons for inconsistency in the ranking of the two projects.
Best Answer - Chosen by Asker
We have a ranking problem with these two project as the cash flow pattern is inconsistent between the two. Project X has mixed cash flows which rise in the first three years then drop off where as Project Y has cash flows that decrease from year 1 onwards. Project Y seems very unusual since the first net cash flow covers up the initial expense yet the succeeding years have menial net cash flows.
If this exercise was crafted only to product conflicting IRR and NPV results then the professor had too much time on his hands to come up with meaningless project evaluation exercise
When in real life we are faced with ranking issues of this nature where patterns of cash flow differ for equal life projects, we are likely to chose a project with the highest NPV the reason lies with the fact that in computing NPV we assume the reinvestment rate is same for both project which is usually the discount rate or the cost of capital in this case 10%. This differs from the assumption in computing IRR where the reinvestment rate is different for both projects since IRR is considered the reinvestment rate and it will be different for both projects as is the case here.
The more meaningful method to apply in this situation will be MIRR where the reinvestment rate is same for both projects that is 10% and this shows that the second project which has the highest IRR in fact has lowest MIRR
Following are the results of different methods for these two projects.
Try the financial calculators here http://thinkanddone.com/blog/online-calc… to get the results
-200 35 80 90 75 20
IRR = 15.62%
NPV = $29.2
MIRR = 13.04 %
payback period is 3.67 years
Profitability Index = 1.15
-200 218 10 10 4 3
IRR = 18.73%
NPV = $18.55
MIRR = 11.97%
payback period is 1.22 years
Profitability Index = 1.09
Source(s):
http://thinkanddone.com/
