Question No: 4

The NPV and IRR of both projects could be calculated as illustrated in the exhibits-5 & 6 below. The NPV of Synthetic Resin amounts to $903,021 and the NPV of Epoxy Resin was $562,214, which was lower than the NPV of Synthetic Resin. Additionally, the ARR rate of Synthetic Resin was higher than Epoxy Resin. Hence, according to these variables synthetic Resin project should be accepted, under mutually exclusive project. However, it can be assessed that, the IRR calculated for Synthetic Resin was 24% and for Epoxy Resin was 30%. This meant that, according to IRR the Epoxy Resin project was more attractive than the Synthetic Resin project. Therefore, it can be determined that, the IRR can sometimes be misleading, which would compromise the management’s ability to make effective decisions regarding the potential investment opportunity.

Exhibit-5

Synthetic Resin
Discount factor @ 10%                1.000           0.909           0.826           0.751           0.683           0.621
Present value  $ (1,000,000)  $  318,182  $  330,579  $  375,657  $  443,959  $  434,645
Net present value  $       903,021
IRR 24%

Exhibit-6

Epoxy Resin
Discount factor @ 10%            1.000           0.909           0.826           0.751           0.683           0.621
Present value  $ (800,000)  $  545,455  $  330,579  $  225,394  $  136,603  $  124,184
Net present value  $   562,214
IRR 30%

 

Question No: 5

The NPV profile of the two mutually exclusive project has been constructed and represented in the Exhibit-7 below,in which, the NPV of both projects has been calculated at variable discount rates from 0% to 40% to depict the changes on NPV with respect to the change in discount rate. Furthermore, it can be evaluated that, the point at which, the NPV of project-1 and project-2 are equal is known as crossover point, after which, if the discount factor decrease the NPV of one project would crossover the other. Hence, it was necessary for the management to estimate the crossover point, so that they could make effective decisions regarding the project, if the cost of capital was to increase unexpectedly. However, the crossover point was calculated by estimating the change in cash flows of the two projects and taking the IRR of these values, to determine the crossover point at 29.17. Whereas, the IRR of Project-1 was 24% and project-2 was 30%, which meant that project-2 was above the crossover point calculated. Therefore, according to IRR calculation project-1 should be accepted. However, it has been evaluated that, the NPV and ARR of project-2 is higher than project-1. Therefore, it can be determined that, the IRR can sometimes mislead the management of the organization, as it could give unsubstantial results. On the other hand, NPV provides a constant source to identify the present value of the returns that would be gained from the project in its life. Hence, the NPV is a more appropriate method to determine the fair value of the project.

Exhibit-7

Year Project-1 Project-2 CF Change
0  $   (1,000,000)  $      (800,000)  $ (200,000)
1  $       350,000  $       600,000  $ (250,000)
2  $       400,000  $       400,000  $               –
3  $       500,000  $       300,000  $   200,000
4  $       650,000  $       200,000  $   450,000

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