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1. Mesa Products Inc. requires a new machine to produce a part for a solar air conditioner. Two companies have submitted bids, and you have been assigned the task of choosing one of the machines. Cash flow analysis indicates the following:

Year Machine A Machine B
0 -1,000 -1,000
1 0 417
2 0 417
3 0 417
4 1,938 417

If the cost of capital for Mesa is 5%, which one of the following statements is the most valid?

a. Project B because of higher NPV
b. Project A because of higher NPV
c. Project A because of higher IRR
d. Project B because of higher IRR
e. Neither, because both projects have IRRs less than the cost of capital

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HOMEWORK PRACTICE PROBLEM

1. Mesa Products Inc. requires a new machine to produce a part for a solar air conditioner. Two companies have submitted bids, and you have been assigned the task of choosing one of the machines. Cash flow analysis indicates the following:

Year Machine A Machine B
0 -1,000 -1,000
1 0 417
2 0 417
3 0 417
4 1,938 417

If the cost of capital for Mesa is 5%, which one of the following statements is the most valid?

a. Project B because of higher NPV
b. Project A because of higher NPV
c. Project A because of higher IRR
d. Project B because of higher IRR
e. Neither, because both projects have IRRs less than the cost of capital

 Step 1: Compute the NPV for both the machines. Note that r = 0.05 or 5%
NPV (machine A) = Year 0 cash flow + Year 1 cash flow/(1+r) + Year 2 cash flow/(1+r)2 + Year 3 cash flow/(1+r)3 + Year 4 cash flow/(1+r)4

NPV (machine A) = -1000 + 0/(1+0.05) + 0/(1+0.05)2 + 0/(1+0.05)3 + 1938/(1+0.05)4
NPV (machine A) = -1000 + 1594.397
NPV (machine A) = \$594.397

NPV (machine B) = Year 0 cash flow + Year 1 cash flow/(1+r) + Year 2 cash flow/(1+r)2 + Year 3 cash flow/(1+r)3 + Year 4 cash flow/(1+r)4

NPV (machine B) = -1000 + 417/(1+0.05) + 417/(1+0.05)2 + 417/(1+0.05)3 + 417/(1+0.05)4
NPV (machine B) = -1000 + 417* 0.95238 + 417* 0.90702 + 417* 0.86383 + 417* 0.82270
NPV (machine B) = \$478.661

Step 2: Compare: Select the machine with higher NPV.
For machine A NPV is greater than machine B.
Also, it can be shown that IRR for both the machines is higher than cost of capital