Q38PGB - Horngren'S Financial And Managerial Accounting

Question

Hamilton Company is considering two capital investments. Both investments have an initial cost of \(7,000,000 and total net cash inflows of \)16,000,000 over 10 years. Hamilton requires a 20% rate of return on this type of investment. Expected net cash inflows are as follows:

Year	Plan Alpha	Plan Beta
1	\(1,600,000	\)1,600,000
2	\(1,600,000	2,200,000
3	\)1,600,000	2,800,000
4	\(1,600,000	2,200,000
5	\)1,600,000	1,600,000
6	\(1,600,000	1,500,000
7	\)1,600,000	1,300,000
8	\(1,600,000	1,100,000
9	\)1,600,000	900,000
10	\(1,600,000	800,000
Total	\)16,000,000	\(16,000,000

Requirements 

1. Use Excel to compute the NPV and IRR of the two plans. Which plan, if any, should the company pursue? 

2. Explain the relationship between NPV and IRR. Based on this relationship and the company’s required rate of return, are your answers as expected in Requirement 1? Why or why not? 

3. After further negotiating, the company can now invest with an initial cost of \)6,500,000. Recalculate the NPV and IRR. Which plan, if any, should the company pursue?

Step-by-Step Solution

Answer

1.  The company should pursue plan Beta with a positive NPV.

	Plan Alpha	Plan Beta
NPV	($292,044.66)	$610,050.83
IRR	18.76%	22.89%

 

2.  NPV and IRR have direct relation.

3.  When the initial investment declines to $6,500,000, plan beta must be selected because of higher NPV and IRR.

	Plan Alpha	Plan Beta
NPV	$207,955.34	$1,110,050.83
IRR	20.94%	25.59%

Step 1: Definition of Internal Rate of Return

The internal rate of return is the metric used in capital budgeting to determine the project’s profitability. IRR is calculated using the same formula as used for NPV. Under calculation of IRR net present value is considered as 0.

Step 2: Calculation of NPV and IRR using excel

Project	Plan Alpha		Plan Beta
Useful life	10		10
Discount rate	0.2		0.2
Initial investment	-7000000		-7000000
1	1600000		1600000
2	1600000		2200000
3	1600000		2800000
4	1600000		2200000
5	1600000		1600000
6	1600000		1500000
7	1600000		1300000
8	1600000		1100000
9	1600000		900000
10	1600000		800000
Total	16,000,000		16000000
Outputs
NPV	($292,044.66)		$610,050.83
IRR	18.76%		22.89%

Excel formula for NPV: =NPV(Discount rate, Cash flow from 1^st year to 10^th year)+Initial investment

Excel formula for IRR: =IRR(All cash flows from year 1^st year to 10^th year including initial investment)

Step 3: Relationship between IRR and NPV

It can be said that the IRR and NPV have a direct relationship with each other. So, the higher the NPV higher the IRR, and the lower the NPV, the lower the IRR. The results of requirement 1 are not as expected because the net present value of plan A is negative, and its IRR is still higher than plan B. It is so because the negative value of the NPV is higher than the positive value of the NPV. 

Step 4: When the initial investment is $6,500,000

Project	Plan Alpha			Plan Beta
Useful life	10			10
Discount rate	0.2			0.2
Initial investment	-6500000			-6500000
1	1600000			1600000
2	1600000			2200000
3	1600000			2800000
4	1600000			2200000
5	1600000			1600000
6	1600000			1500000
7	1600000			1300000
8	1600000			1100000
9	1600000			900000
10	1600000			800000
Total	16,000,000			16000000
Outputs
NPV	$207,955.34			$1,110,050.83
IRR	20.94%			25.59%

Excel formula for NPV: =NPV(Discount rate, Cash flow from 1^st year to 10^th year)+Initial investment

Excel formula for IRR: =IRR(All cash flows from year 1^st year to 10^th year including initial investment)