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

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 :

1. Calculate the NPV and IRR of each project.
2. State, with reasons, which of the two mutually exclusive projects you would recommend.
3. Explain the reasons for inconsistency in the ranking of the two projects. 

Solution: BY NPV METHOD:

NPV is the sum of all terms  ,

-200/(1.1)=-200

 35/1.1=31.82

 80/1.21=66.21

 90/1.331=67.62

 75/1.4641=51.23

 20/1.61051=12.42     here 200-all 5 above

200-229.21=  -29.21 for x

For y:

-200/1.1=-200

218/1.1=198.18

10/1.21=8.26

10/1.331=7.51

4/1.4641=2.73

3/1.61051=1.86

Here 200- all 5 above

200-218.54 = -18.54

BY IRR METHOD:

rate of return is given by r in:

-200+31.82+66.12+67.62+51.23+12.42 = 29.3 for x

-200+198.18+8.26+7.51+2.73+1.86 = 18.54 for y