You have just started your summer internship, and your boss asks you to review a recent analysis...

Question

You have just started your summer internship, and your boss asks you to review a recent analysis that was done to compare three alternative proposals to enhance the firm’s manufacturing facil- ity. You find that the prior analysis ranked the proposals according to their IRR, and recom- mended the highest IRR option, Proposal A. You are concerned and decide to redo the analysis using NPV to determine whether this recommendation was appropriate. But while you are confident the IRRs were computed correctly, it seems that some of the underlying data regard- ing the cash flows that were estimated for each proposal was not included in the report. For Proposal B, you cannot find information regarding the total initial investment that was required in year 0. And for Proposal C, you cannot find the data regarding additional salvage value that will be recovered in year 3. Here is the information you have:

Proposal	IRR	Year 0	Year 1	Year 2	Year 3
A	XXXXXXXXXX%	XXXXXXXXXX	30	153	88
B	XXXXXXXXXX%	?	0	206	95
C	XXXXXXXXXX%	XXXXXXXXXX	37	0	204 + ?

Suppose the appropriate cost of capital for each alternative is 10%. Using this information, determine the NPV of each project. Which project should the firm choose?

Why is ranking the projects by their IRR not valid in this situation?

David · Accepted Answer

SOLUTION a: 
Project A: NPV (A) = -100 + (30 / 1.10) + (153 / (1.10^2)) + (88 / (1.10^3)) 
Project A: NPV (A) = $119.83 
Project B: IRR is to be used to determine the initial cash flow. 
CF (B) = -(206 / (1.55^2)) + (95 / (1.55^3)) 
CF (B) = -$111.25 
Thus, NPV (B) = -111.25 + 0 / 1.

You have just started your summer internship, and your boss asks you to review a recent analysis that was done to compare three alternative proposals to enhance the firm’s manufacturing facil- ity....

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