You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $ 10 million. Investment A will generate $ 2.4 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $ 1.8 million at the end of the first year, and its revenues will grow at 4.5 % per year for every year after that. Use the incremental IRR rule to correctly choose between investments A and B when the cost of capital is 6.4 %. At what cost of capital would your decision change?

Question

Johan Dickson

Business

5 August, 14:35

You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $ 10 million. Investment A will generate $ 2.4 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $ 1.8 million at the end of the first year, and its revenues will grow at 4.5 % per year for every year after that. Use the incremental IRR rule to correctly choose between investments A and B when the cost of capital is 6.4 %. At what cost of capital would your decision change?

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Answers (1)

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Lorelai Shepard · Answer 1

A) Choose A B) Choose B C) 0.45

Explanation:

We will use the NPV formula to calculate the IRR and them choose investment opportunity with a high IRR

NPV (A) = CF/R - II

0 = 2.4/r - 10 m

r=0.24/24%

NPV (B) = 1.8/r-0.045-10

0=1.8/r-0.045-10

r=0.135/13.5%

Therefore choose A

B) NPV (A)

=2.4/0.064-10

=$27.5 MIL

NPV (B)

=1.8/0.064-0.045 - 10

=1.8/0.019-10

=$84.74 MIL

Therefore choose B as it has higher NPV

C) Equate the NPV to in order to calculate the cost of capital

2.4/r - 10 = 1.8/r-0.045 - 10

2.4/r=1.8/r-0.045

1.8r=2.4r-0.108

0.6r=0.108

r=0.556/5.56%

=