Question

2. Robert Washington, president of the Sunshine Hotel, is considering two investments projects. Only one of the two will be selected this year. Information regarding each project is as follows: Project 1: Renovate an existing motel for $1,000,000. After tax, free cash flows are expected to be 200,000 per year for twenty years. Project 2: Build a new motel for $4,000,000. After tax, annual cash flows for twenty years are expected as follows: Free Cash Flow Year -200,000 -50,000 200,000 600,000 1,100,000 5-20 Assume a discount rate of 12 percent. Required: 1) Based on the NPV model, which of the two projects would be selected? 2) Based on the IRR model, which of the two projects would be selected? 3) Which model would you prefer, why?

Answer 1

1.Project 1

Net present value can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$1,000,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the discount rate of 12%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The net present value is $493,888.72.

Project 2

Net present value can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$4,000,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the discount rate of 12%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The net present value is $1,180,539.48.

Project 2 should be selected as per the net present value since it has the highest net present value.

b. Project 1

Internal rate of return can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$1,000,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR button and enter the interest rate to get the IRR of the project.

The IRR is 19.43%.

Project 2

Internal rate of return can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$4,000,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR button and enter the interest rate to get the IRR of the project.

The IRR is 15.02%.

Project 1 should be selected as per the internal rate of return method since it has the highest internal rate of return

3.I would prefer the net present value model. The reason is that the reinvestment at the discount rate is the superior assumption, so when mutually exclusive projects are evaluated, the NPV approach should be used for the capital budgeting decision. The project selected by the net present value is chosen since the firm will be able to maximize the wealth of the shareholders. The NPV method is more reliable compared to IRR method in case of mutually exclusive projects.

In case of any query, kindly comment on the solution.