Question

(Size effect) Montebano, Inc. plans to choose between two manually exclusive projects. The first one, A, is a larger project costing $2,500,000 initially and generates $270,000 each year. Project A is expected to last 10 years. A smaller project, B has an initial cost of $300,000 and is expected to produce free cash flows of $50,000 per year over 10 years. Montebano has a weighted average cost of capital of 12%.

a. Calculate the NPV, and IRR.

b. Which project should be accepted?

c. Discuss the facts of this problem and the effects of Montebano's decision.

Answer 1

Year	Project A	PV @12%	PV	PV @1%	PV	Project B	PV @12%	PV	PV @1%	PV
1	270000	0.8929	241071	0.9901	267327	50000	0.8929	44643	0.9901	49505
2	270000	0.7972	215242	0.9803	264680	50000	0.7972	39860	0.9803	49015
3	270000	0.7118	192181	0.9706	262059	50000	0.7118	35589	0.9706	48530
4	270000	0.6355	171590	0.9610	259465	50000	0.6355	31776	0.9610	48049
5	270000	0.5674	153205	0.9515	256896	50000	0.5674	28371	0.9515	47573
6	270000	0.5066	136790	0.9420	254352	50000	0.5066	25332	0.9420	47102
7	270000	0.4523	122134	0.9327	251834	50000	0.4523	22617	0.9327	46636
8	270000	0.4039	109048	0.9235	249340	50000	0.4039	20194	0.9235	46174
9	270000	0.3606	97365	0.9143	246872	50000	0.3606	18031	0.9143	45717
10	270000	0.3220	86933	0.9053	244427	50000	0.3220	16099	0.9053	45264
	Total Inflow		1525560		2557252			282511		473565
	Intial Outflow		2500000		2500000			300000		300000
a)	NPV (A-B)		-974440		57252			-17489		173565
	NPVa @ 1%		57252			NPVa @ 1%		173565
	NPVb @ 12%		-974440			NPVb @ 12%		-17489
	Ra		1.00%			Ra		1.00%
	Rb		12.00%			Rb		12.00%
	IRR = Ra + (NPVa * (Rb - Ra)) / NPVa- NPVb
	IRR = 1% + ( 57252 * (12%-1%)) / 57252- (-974440)					IRR = 1% + (173565 * (12%-1%)) / 173565- (-17489)
	IRR = 1% + ( 57252 * 11% / 57252- (-974440)					IRR = 1% + (173565 * 11% / 173565- (-17489)
	IRR = 1% + ( 57252 * 11% / 57252+974440					IRR = 1% + (173565 * 11% / 191054
	IRR = 1% + 6297 / 1031692					IRR = 1% + 19092 / 191054
	IRR = 1% + 0.006					IRR = 1% + 0.099
a)	IRR = 1.006%					IRR = 1.099%
b)	Non of the project is viable as NPV is negative in both the cases and IRR is less than cost of capital …i.e. 12%
c)	Project initial cost is two high as comparative to PV inflow in 10 years for both of the cases
	Projected cost of capital is high as compare to IRR for both the cases
	The Scarp Value from both the project is NIL
	The project is not acceptable as both the project creating wealth