The Finance Director of Ritoria Ltd thinks that the project with the higher NPV should be chosen whereas its Managing Director thinks that the one with the higher IRR should be undertaken, especially as both projects have the same initial outlay and length of life. The company anticipates a cost of capital of 10% and the net after tax
cash flows of the projects are as follows:
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| (Cash Flows figs 000) | | | | | | |
| Project X | Rs. (200) | 35 | 80 | 90 | 75 | 20 |
| Project Y | Rs. (200) | 218 | 10 | 10 | 4 | 3 |
You are required to :
a. Calculate the NPV and IRR of each project.
|
c. Explain the reasons for inconsistency in the ranking of the two projects.
| 10% | 20% | 000 | 000 | 000 | 000 | 000 | 000 |
| 1.000 | 1.000 | (200) | (200.00) | (200.00) | (200) | (200.00) | (200.00) |
| 0.909 | 0.833 | 35 | 31.82 | 29.16 | 218 | 198.16 | 181.59 |
| 0.826 | 0.694 | 80 | 66.08 | 55.52 | 10 | 8.26 | 6.94 |
| 0.751 | 0.579 | 90 | 67.59 | 52.11 | 10 | 7.51 | 5.79 |
| 0.683 | 0.482 | 75 | 51.23 | 36.15 | 4 | 2.73 | 1.93 |
| 0.621 | 0.402 | 20 | 12.42 | 8.04 | 3 | 1.86 | 1.21 |
| | | NPV | 29.14 | (19.02) | NPV | 18.52 | (2.54) |
@10% NPV Project Y = £18,520
@20% NPV Project X = (£19,020)
@20% NPV Project Y = (£2,540) IRR Project X=16%
IRR Project Y=18%
(b) Undertake Project X:
it has a positive NPV, indicating that it exceeds the company’s cost of capital;
assuming that the company’s objective is to maximise the present value of future cash flows X offers the higher NPV.
X offers a higher NPV, whereas Y offers a high IRR. Where such conflicting indications appear it is generally appropriate to accept the NPV result, NPV being regarded as technically more sound than IRR.
(c) The two projects have redically different time projiles. X’s cash inflows are grouped in the three middle years of the project. This leads to Y showing a higher IRR.
Risk, uncertainty and timing of cash flows may be considered by the directors in making the final investment decisions.
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