1 answer

5. You are deciding between two mutually exclusive investment projects. Both require the same upfront investment...

Question:

5. You are deciding between two mutually exclusive investment projects. Both require the same upfront investment of $9.8 million. Investment A will generate $2 million per year in perpetuity (starting from the end of the first year) and Investment B will generate $1.45 million per year at the end of first year and, after the first year, its revenue will grow at 2.6% per year in perpetuity. The discount rate is 7.8%.
a) Which project has a higher IRR? [7.5 marks]
b) Which project would you choose to invest? Why? [7.5 marks]
5. You are deciding between two mutually exclusive investment projects. Both require the same upfront investment of S9.8 mill
5. You are deciding between two mutually exclusive investment projects. Both require the same upfront investment of S9.8 million. Investment A will generate S2 million per year in perpetuity (starting from the end of the first year) and Investment B will generate $1.45 million per year at the end of first year and, after the first year, its revenue will grow at 2.6% per year in perpetuity. The discount rate is 7.8%. a) Which project has a higher IRR? [7.5 marks] b) Which project would you choose to invest? Why? [7.5 marks]

Answers

NPV of project A = Initial cost + PV of cash flows

= -9.8+ 2/7.8%

=$15.84 million

IRR is that rate at which

9.8 = 2/IRR

IRR = 2/9.8= 20.41%

NPV of project B = Initial cost + PV of cash flows

= -9.8+ 1.45/(7.8%-2.6%)

=$18.08 million

IRR is that rate at which

9.8 = 1.45/ (IRR-0.026)

IRR- 0.026 = 1.45/9.8 = 0.147959

IRR = 0.147959+ 0.026

= 17.39%

A: Project A has a higher IRR.

B: Project B will be chosen since it has higher NPV and hence the value of the business increases.

.

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