Question

Net Present Value Versus Internal Rate of Return For discount factors use Exhibit 12B-1 and Exhibit 12B-2. Skiba Company is thinking about two different modifications to its current manufacturing process. The after-tax cash flows associated with the two investments follow: Project I Project II $(100,000) 63,857 63,857 Year $(100,000) 134,560 Skiba's cost of capital is 16%. Required 1. Compute the NPV and the IRR for each investment. Round present value calculations and your final NPV answers to the nearest dollar. Round IRR answers to the nearest whole percent. NPV IRR 161 % Project I Project II 2. Conceptual Connection: Explain why the project with the larger NPV is the correct choice for Skiba. NPV is an absolute profitabilitymeasure and reveals how much the value of the firm will change for each project. IRR gives a measure of relative profitability.Thus, since NPV reveals the total wealth change attributable to each project, it is preferred to the IRR measure. 13,793 4,766 X 18 %

Answer 1

Solution to 1- Net Present Value method of capital budgeting uses the discount rates specified to calculate the future values of cash inflows to present discounted value at the time of actual cash outflows.

Calculation of Net Present Value:

NPV = Present value of cash inflows - Present value of cash outflows

(Present value is calculated with the help of Exhibit 12B.1)

Project 1- Present value of cash inflows = 134560*0.74316 = 99999.6 (Rounding of to nearest dollar=100000)

Cash outflows = 100000

NPV = 100000 - 100000 =0

Therefore, NPV of project 1 is 0

Project 2- Present value of cash inflows = (63857*0.86207) + (63857*0.74316) = 102505.16 (Rounding of=102505)

Cash outflows = 100000

NPV = 102505 - 100000 = 2505

Calculation of Internal Rate of Return:

Internal Rate of Return is a discount rate that equates the present value of expected cash outfows with cash inflows

Therefore,Internal Rate of Return = cash inflows/cash outflows = 1

(IRR is calculated by basic trial and error by the help of Exhibit 12B.1)

Project 1- Present value of cash inflows =134560*0.74316 = 100000 (99999.6) (16% is taken by trial and error as it was closest to equate present value of cash inflows with cash outflows)

Cash outflows = 100000

Therefore Internal rate of return for project 1 = 16%

Project 2- Present value of cash inflows = (63857*0.86207) + (63857*0.74316) = 102505 (16% is substituted by trial and error)

But as we can see that 16% is not equating present value of cash inflows with cash outflows,therefore we will substitute 18% is it will lower the value of cash inflows

Present value of cash inflows = (63857*0.84746) + (63857*0.71818) = 99980 (18% is substituted by trial and error)

Internal rate of return = 16% + (102505-100000)/102505-99980)*(18-16) = 16% + 1.984% = 17.984%(Rounding of to nearest percentage = 18%)

Therefore Internal rate of return for project 2 = 18%

Solution to 2-  NPV and IRR differ in the sense that result under certain circumstances are mutually contradictory under two methods.This happens mostly in the case of mutually exclusive proposals,where one favours one project and the other favours the other project. NPV is an gives an absolute result in the form of cash flows whereas IRR provides a relative result in the form of percentages.therefore the decision making become easier as all we have to do is to prefer the project with higher NPV.