Practice Problems for Quiz 2
Part I
1. Your company is considering two projects with the following cash flows:
Time
0
1
2
3
4
5
Project A
Project B
Cash Flow
Cash Flow
-22,000
-50,000
6,000
20,000
7,000
15,000
8,000
15,000
9,000
13,000
10,000
13,000
a) Calculate the IRR for each project.
Answer: See next page for solutions.
b) If these projects are independent, and a required return of 10% is used as the discount
rate, identify which project(s) you would accept? Clearly explain the logic behind
your decision.
Answer: Both. Both have positive NPV and IRR higher than required return.
c) If these projects are mutually exclusive, and a required return of 10% is used as the
discount rate, identify which project(s) you would accept? Clearly explain the logic
behind your decision.
Answer: B. Higher NPV at 10%.
d) Assume that you can accept only one of the projects (if any are acceptable). Also
assume that the CFO is uncertain about what discount rate to use. She is now
thinking that perhaps a 14% discount rate is appropriate. Which project would you
accept if the required return is 14%?
Answer: A. Higher NPV at 14%.
e) Construct an NPV profile to show how the choice of projects is sensitive to the
discount rate used. Carefully explain the conclusions that can be drawn from the
NPV profile. (Hint, this involves the incremental IRR).
Answer: See next page.
F301
1
Project A Project B Difference
cash flows cash flows
(B - A)
(22,000)
(50,000)
(28,000)
6,000
20,000
14,000
7,000
15,000
8,000
8,000
15,000
7,000
9,000
13,000
4,000
10,000
13,000
3,000
Time
0
1
2
3
4
5
IRR =
21.6%
17.3%
12.2%
NPV @
10% 7,606.52
8,799.39
14% 4,571.61
3,659.28
23%
(711.91) (5,467.06)
NPV profile:
10,000
8,000
6,000
4,000
2,000
Project A
0
Project B
(2,000)
(4,000)
(6,000)
(8,000)
8%
12%
16%
20%
24%
Conclusions for mutually exclusive projects:
At discount rates below 12.2% (the crossover rate or incremental
IRR), choose B, because it has a higher NPV.
At discount rates between 12.2% and 21.6% (which is A's IRR),
choose A, because it has a higher NPV when using discount rates in
that range.
At discount rates above 21.6%, reject both projects. Above that rate,
both projects have negative NPV.
F301
2