14.5: Calculating Net Present Value and Internal Rate of Return for Mutually Exclusive Projects

Why:

For competing projects, the discounting method that consistently chooses the wealth-maximizing project should be used. NPV measures profitability in absolute terms, while IRR measures relative profitability. NPV measures the amount by which the value of the firm changes and thus is consistent with maximizing wealth.

Information:

Consider two pollution prevention designs: Design A and Design B. Both designs have a project life of 5 years. Design A requires an initial outlay of $180,000 and has a net annual after-tax cash inflow of $60,000 (revenues of $180,000 minus cash expenses of $120,000). Design B, with an initial outlay of $210,000, has a net annual cash inflow of $70,000 ($240,000 $170,000). The after-tax cash flows are summarized as follows:

CASH FLOW PATTERN
Year	Design A	Design B
0	$(180,000)	$(210,000)
1	60,000	70,000
2	60,000	70,000
3	60,000	70,000
4	60,000	70,000
5	60,000	70,000

The cost of capital for the company is 12%.

Required:

Calculate the NPV and the IRR for each project.

Solution:

DESIGN A: NPV ANALYSIS
Year	Cash Flow	Discount Factor*	Present Value
0	$(180,000)	1.00000	$(180,000)
15	60,000	3.60478	216,287
Net present value			$ 36,287

DESIGN A: IRR ANALYSIS