The High Flying company (HFGC) has been gowing very rapidly in recent years making its shareholders rich in the process. The average annual rate of return on the stock in the last few years has been 19% and HFGC managers believe that 19% is a reasonable figure for the firm's cost of capital. To sustain a high growth rate the HFGC CEO argures that the company must continue to invest in projects that offer the highest rate of return possible. Two projects are currently under review. The first is an expansion of the firm's production capacity and the second project involves introducing one of the firm's existing products into a new market. Cash flows from each project appear in the following table.
a: calculate the NPV for both projects. Rank the projects based ontheir NPV's.
b: calculate the IRR for both projects. Rank the projects based on their IRR's.
c: calculate the PI for both projects. Rank the projects based ontheir PI's.
d: the firm can only afford to undertake one of these investments. What do you thinkthe firm should do?
TABLE
Year Plant expansion Product introduction
0 -3,500,000 -400,000
1 2,000,000 375,000
2 2,750,000 275,000
3 2,500,000 250,000
4 1,750,000 250,000