Textbook Problem

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Covington Pharmacies has decided to automate its insurance claims process. Two networked computer systems are being considered. The systems have an expected life of two years. The net cash flows associated with the systems are as follows. The cash benefits represent the savings created by switching from a manual to an automated system.

The company’s cost of capital is 10 percent.

Required:

1. 1. Compute the NPV and the IRR for each investment.
2. 2. Show that the project with the larger NPV is the correct choice for the company.

To determine

Ascertain the net present value and the internal rate of return for each investment.

Explanation of Solution

Internal rate of return method (IRR): Internal rate of return method is one of the capital investment methods which determine the rate of return, wherein the net present value of all the cash flows (both positive and negative) from an investment is zero. This method is also called as the time-adjusted rate of return method. It used to evaluate the different proposal’s expected rate of return.

Net present value method (NVP): Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is desired by the business based on the net income from the investment, and it is also called as the discounted cash flow method.

Ascertain the net present value for each investment:

System I:

Year	Cash flow (A)	Discount factor @ 10% (B)	Present value $\left(A\times B\right)$
1	-	-	0
2	$162,708	0.826	$134,397
Less: cost of investment			120,000
Net present value			$14,397

Table (1)

System II:

Year	Cash flow (A)	Discount factor @ 10% (B)	Present value $\left(A\times B\right)$
1	$ 76,628	0.910	$69,731
2	$ 76,628	0

To determine

State whether the project with the larger Net Present Value is the correct choice for the company.