6 Consider the following cash flows Which project should be

6. Consider the following cash flows: Which project should be selected as the base alternative? Determine the IRR on the incremental investment. Which alternative should be recommended at MARR= 10%? A1 $3000 1,350 A2 -$12,000 4,200 6,225 6,330 1,800 1,500

R = 10%

For Alternative A1:

Present value of cash inflows = 1350/1.1 + 1800/1.1^2 + 1500/1.1^3 = $3841.85

Profitability index = present value of cash inflows/initial investment = 3841.85/3000

Profitability index = 1.28

NPV = 3841.85-3000 = $841.85

To calculate the return:

At R = 25%

Present value of cash inflows = $2000

So, rate of return is 25%.

For Alternative A2:

Present value of cash inflows = 4200/1.1 + 6225/1.1^2 + 6330/1.1^3 = $13718.63

Profitability index = present value of cash inflows/initial investment = 13718.63/12000

Profitability index = 1.14

NPV = 13718.63 – 12000 = $1718.63

To calculate the return:

At R = 17.425% ( by trial and error method)

Present value of cash inflows = $12000

So, the rate of return for the A2 is 17.425%.

Since the profitability index as well as the rate of return of alternative A1 is higher than that of the alternative A2, so Alternative A1 should be selected.

If the sole criteria is the wealth maximization by the amount of new profit, then A2 has the higher NPV than that of A1. So, on the sole criteria of NPV, A2 should be selected.

For incremental analysis (A2 over A1):

Incremental investment = -12000 – (-3000) = -$9000

Incremental cash inflow in year 1 = 4200-1350 = $2850

Incremental cash inflow in year 2 = 6225-1800 = $4425

Incremental cash inflow in year 3 = 6330-1500 = $4830

At R = 15%

Present value of incremental cash inflows = $9000

So, IRR = 15%