Ec 1745 Fall 2008 Problem Set 2
Ec 1745 Fall 2008 Problem Set 2
1. a) NPV=C0+(C1/(1+r))+…+(Ct/((1+r)t))
NPV(Red Pig)=-400+(250/(1.09))+(300/(1.092))=$81.86
NPV(Caffeine Delight)=-200+(140/(1.09))+(179/(1.092))=$79.10
Following the NPV rule, Coca Cola should produce Red Pig
b) The IRR rule tells us that the project with the higher IRR can stand a higher
cost of capital and still be a positive NPV project and that we should invest in
a project if the IRR > cost of capital. However, in this case both projects have
an IRR that is greater than the cost of capital (9%), so we can’t simply use
this rule to tell us which project to invest in. What we can do is create another
synthetic project that measures the differences between the two projects and
then calculate the IRR for this synthetic project to see if one should invest in
it, if one should, then the result is the same as part a).
Project Synthetic Payoffs:
Year 0 Year 1 Year 2
-400-(-200)=-200 250-140=110 300-179=121
NPV=-200+(110/(1+r))+(121/(1+r)2)=0
r=.1 so IRR=10%
Since the IRR for the synthetic project is greater than the cost of capital, you
should take on both the synthetic project and the Caffeine Delight project,
which is the same thing as taking on the Red Pig Project. Thus, by using this
method we achieve the same result as in part a).