The Pinkerton Publishing Company is considering two mutually exclusive

QUESTION

The Pinkerton Publishing Company is considering two mutually exclusive expansion plans. Plan A calls for the expenditure of $50 million on a large-scale, integrated plant which will provide an expected cash flow stream of $8 million per year for 20 years. Plan B calls for the expenditure of $15 million to build a somewhat less efficient, more labor-intensive plant which has an expected cash flow stream of $3.4 million per year for 20 years. The firms cost of capital is 10 percent. a. Calculate each projects NPV and IRR.b. Set up a Project _ by showing the cash flows that will exist if the firm goes with the large plant rather than the smaller plant. What are the NPV and the IRR for this Project _?c. Graph the NPV profiles for Plan A, Plan B, and Project _.d. Give a logical explanation, based on reinvestment rates and opportunity costs, as to why the NPV method is better than the IRR method when the firms cost of capital is constant at some value such as 10 percent.
Solution: a. Step 1: Plot all the cash flows including initial investment Step 2: To calculate NPV= NPV (all cash flows starting from year 1)+investment in year 0 Step 3: To calculate IRR=IRR(all cash flows from year 0 to year 20) Cost of capital 10% Time in Years 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Cash Flow in $ -50 8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 PV of cash flows -50 7.272727 6.61157 6.010518 5.464108 4.967371 4.515791 4.105265 3.732059 3.392781 3.084346 2.803951 2.549047 2.317315 2.10665 1.915136 1.741033 1.582757 1.43887 1.308064 1.189149 NPV in $ -12.75 IRR 5% Cost of capital 10% Time in Years 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Cash Flow in $ -15 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 PV of cash flows -15 3.090909 2.809917 2.55447 2.322246 2.111132 1.919211 1.744738 1.586125 1.441932 1.310847 1.191679 1.083345 0.984859 0.895326 0.813933 0.739939 0.672672 0.61152 0.555927 0.505388 NPV in $ 0.83 IRR 11% b. If investment in bigger project (Plan A) is lower ar $35 million then the NPV is $2.25 million which is higher than Plan B.and IRR is 11% which is equal to Plan B.So we should go with Plan A Cost of capital 10% Time in Years 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Cash Flow in $ -35 8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 PV of cash flows -35 7.272727 6.61157 6.010518 5.464108 4.967371 4.515791 4.105265 3.732059 3.392781 3.084346 2.803951 2.549047 2.317315 2.10665 1.915136¦

.741033 1.582757 1.43887 1.308064 1.189149 NPV in $ 2.25 IRR 11% Cost of capital 10% Time in Years 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Cash Flow in $ -15 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 3.4 PV of cash flows -15 3.090909 2.809917 2.55447 2.322246 2.111132 1.919211 1.744738 1.586125 1.441932 1.310847 1.191679 1.083345 0.984859 0.895326 0.813933 0.739939 0.672672 0.61152 0.555927 0.505388 NPV in $ 0.83 IRR 11% c. Graph https://plus.google.com/photos/+amitkala25/albums/6117817904838973329/6155637914795562754?banner=pwa&authkey=CKDQ5ILdk87Z0AE&pid=6155637914795562754&oid=110762018435438499770 d. NPV is a direct method of contributing the wealth telling the investors how much have they gained from their investment? It considers time value of money and also all the cash flows starting with the initial investment. It also considers the future risk as well thus giving a better forecast. So NPV is based on higher income, sooner profits, and change in discount rates. IRR on the other hand is a break even rate and is ineffective if there are multiple cash flows changing signs. NPV is in terms of monetary value while IRR is in terms of %. So even if the cost of capital is 10%, it hardly makes a difference. NPV is always a better method.

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