3.0 Evaluation of investment project using IRR and NPV.

Scenario:
Ali Paper want to expand their business to Hatyai, Thailand. There are two companies
had proposed their own project to the administrators of Ali Paper. After that, the administrators
conduct a meeting to discuss which project should be accepted if the projects are mutually
exclusive. In this case, mutually exclusive projects are projects in which acceptance of one
project excludes the others from consideration. In such a scenario the best project will be
accepted. Table 1 and 2 are the detailed cash flow of both project A and B offered by two
companies. The cost of capital /discount rate for the company is 12% per annum.

In order to solve Ali Paper to solve this problem, we can actually use NPV and IRR
method in evaluating both projects before making a right decision.

Table 1: Project A

Period (Year) Project

Cash outflow (RM) Cash inflow (RM)
0 25000
1 12500
2 10000
3 7500
4 2500
5 1250

Table 2: Project B

Period (Year) Project

Cash outflow (RM) Cash inflow (RM)
0 25000
1 1300
2 2500
3 8500
4 12000
5 17000
Net present Value (NPV) of project A:

−25000 12500 10000 7500 2500 1250

𝑁𝑃𝑉 = + + + + +
(1 + 0.12)0 (1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3 (1 + 0.12)4 (1 + 0.12)5

𝑁𝑃𝑉 = RM 1769.08

Net present Value (NPV) of project B:

−25000 1300 2500 8500 12000 17000

𝑁𝑃𝑉 = 0
+ 1
+ 2
+ 3
+ 4
+
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)5

𝑁𝑃𝑉 = RM 1476.30

Comment

Both project A and B have a positive net present value and it indicates that both
investment proposal is profitable and worth selecting. However, the economic situation of Ali
Paper causing them can only afford one project at the time. In a situation, where the projects
are mutually exclusive, Ali Paper should choose to approve project A for their business
expansion since the value of its NPV of project A (RM1769.08) is higher than NPV of project
B (RM 1476.30). In other words, a maximum profit can be expected by the shareholder if
project A is chosen.
Internal rate of return (IRR)

Project A

Using trial and error method to find the rate, followed by the formula:

Cost of capital (%) NPVA

14% 851.29
15% 413.23
15.8 72.25
15.9 30.21
16% -11.70

Use the formula to calculate IRR

413.23
𝐼𝑅𝑅 = 15% + × (16% − 15%)
(413.23 − (−11.70))

𝐼𝑅𝑅 = 15.97%
Project B

Using trial and error method to find the rate

Cost of capital (%) NPVB

13% 585.98
13.5% 155.90
13.6% 71.6
13.7 -13.41
14% -264.50

Use the formula to calculate IRR

585.98
𝐼𝑅𝑅 = 13% + × (14% − 13% )
(585.98 − (−264.50))

𝐼𝑅𝑅 = 13.69%

Comment

Both projects are good and ideal in this case because their internal rate of return is
bigger than the cost of capital of the company which is 12%. Based on the value of IRR, project
A will be chosen because it has greater IRR compared to project B. To put it differently, the
higher the IRR on a project and the greater the amount by which it exceeds the cost of capital,
the higher the net cash flows to the investor. Besides, the IRR of project A also indicates that
the shareholder can get back the modal (cash outflow) invested earlier, then the risk of
investment will automatically reduce.
Discussion

From the calculation and analyse of two projects based on their net present value and
internal rate of return, I suggest Ali Paper to choose project A in expanding their business.
This is the best option since there is no contradiction between this two values. A project that
brings higher net present value and higher internal rate of return will definitely yield profit if
there is no other factor affect it, Hopefully, with this analysis and decision Ali Paper able to
expand his company to more and more country successfully.

However, when we compare two projects in some cases, the NPV and IRR may
provide conflicting results. It may be so that one project has higher NPV while the other has a
higher IRR. This difference could occur because of the different cash flow patterns in the two
projects. In this case, it is recommended that we stick to the net present value as a screening
criteria. (David, 2013). The background of such a recommendation is that the reinvestment
rate plays the key role. The basic assumption of the NPV method is that future cash flows are
reinvested at cost of capital rate, and the IRR method assumes that future cash flows are
reinvested at an internal rate of return. Hence, the reinvestment rate equal to the cost of capital
is a more realistic assumption, especially in the long term project.

From my point of view, even we can make use of IRR method it is a great complement
to NPV and will provide you accurate analysis for investment decisions.
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