4. As chief financial officer you must approve or reject projects based upon the gempany's traditional capital budgeting method: the IRR. Your financial analysts recently calculated the cash flows that would be produced by two projects suggested by the marketing department. Half of the marketing team favored one project and the half favored the other project. The cash flow analysis indicated the following cash flows for each project, one called Peanut Butter and the other Chocolate: Year 0 Year 1 Year 2 Year 3 Peanut Butter $3,000 $0 $ 1000 $0 Chocolate $0 $9,053 $0 $9,053 Both projects look pathetic. The Peanut Butter project actually has more dollar outflows than inflows. The Chocolate project does not begin for another year and has future inflows equal to outflows. Nevertheless, in order to evaluate the projects in terms of company policy, you compute the internal rate of return of each project. Sure enough, the internal rate of return of Peanut Butter is -42.265%. The internal rate of return of Chocolate is 0%. Because your company requires a rate of return of 15%, you send out the bad news that both projects are rejected. Several days later the whole marketing department runs into your office with some startling news: in a seminar on working together, they learned the value of teamwork, and they suggest that the two projects be put together to form one great project. None of the revenues or expenses will change, so the combined project looks like this: Year o Year 1 Year 2 Year 3 Reese's Project -$3,000 $9,053 -$1000 $9,053 When plugged into the computer the project produces an IRR = 20%. Because this internal rate of return exceeds the company required return, it looks like both projects can go ahead. a. Write the IRR equations for Peanut Butter and Chocolate and verify the IRRs for each. Are they correct? b. Find the NPV of each project and the combined one using a discount rate of 15% c. Discuss what you would do, and why the internal rate of return did or did not work. 4. As chief financial officer you must approve or reject projects based upon the gempany's traditional capital budgeting method: the IRR. Your financial analysts recently calculated the cash flows that would be produced by two projects suggested by the marketing department. Half of the marketing team favored one project and the half favored the other project. The cash flow analysis indicated the following cash flows for each project, one called Peanut Butter and the other Chocolate: Year 0 Year 1 Year 2 Year 3 Peanut Butter $3,000 $0 $ 1000 $0 Chocolate $0 $9,053 $0 $9,053 Both projects look pathetic. The Peanut Butter project actually has more dollar outflows than inflows. The Chocolate project does not begin for another year and has future inflows equal to outflows. Nevertheless, in order to evaluate the projects in terms of company policy, you compute the internal rate of return of each project. Sure enough, the internal rate of return of Peanut Butter is -42.265%. The internal rate of return of Chocolate is 0%. Because your company requires a rate of return of 15%, you send out the bad news that both projects are rejected. Several days later the whole marketing department runs into your office with some startling news: in a seminar on working together, they learned the value of teamwork, and they suggest that the two projects be put together to form one great project. None of the revenues or expenses will change, so the combined project looks like this: Year o Year 1 Year 2 Year 3 Reese's Project -$3,000 $9,053 -$1000 $9,053 When plugged into the computer the project produces an IRR = 20%. Because this internal rate of return exceeds the company required return, it looks like both projects can go ahead. a. Write the IRR equations for Peanut Butter and Chocolate and verify the IRRs for each. Are they correct? b. Find the NPV of each project and the combined one using a discount rate of 15% c. Discuss what you would do, and why the internal rate of return did or did not work
