A company manufactures car engines and buys in a large number of components from other companies. The company has a choice between two investment projects. It can build a small factory that will manufacture the most expensive components that it currently buys in from third parties. The savings on those components will be very substantial. Alternatively, it can build a large factory that will manufacture all of the components that it currently buys in. There will be a saving on all components manufactured, but the amount saved on the less expensive items will be much smaller. Each investment is equally risky. Which of the following is the most likely when the internal rate of return and net present value from the two projects are compared? A The small factory option has a higher IRR than the large factory option, and a higher NPV. B The small factory option has a higher IRR than the large factory option, and a lower NPV. C The small factory option has a lower IRR than the large factory option, and a higher NPV. D The small factory option has a lower IRR than the large factory option, and a lower NPV. I picked A but the answer is B. Surely if a project is going to produce more savings, then that project will have the highest NPV?
Hi Yes, if a project is going to produce more savings, then that project will have a higher NPV. Here, the large factory will produce all the savings the small factory will make plus some additional savings, but these additional savings aren’t at the same rate. So the small factory has a higher IRR (large factory additional savings aren't at the same rate) but a lower NPV (large factory does produce more savings). Hope this helps Lynn
