Meridian Foods - Mutually Exclusive Packaging Lines with an IRR Conflict
Meridian Foods must choose one of two packaging lines; the plant has room for one only and the current capital budget cannot fund both. The cost of capital is 12%.
Line A costs ₹40,00,000, has a six-year life and no residual value, and is expected to generate net cash inflows of ₹12,00,000 in each of the six years. Line B costs ₹24,00,000, has a five-year life, generates ₹8,00,000 a year for five years, and is expected to be sold for ₹2,00,000 at the end of year 5.
The product packed by these lines will be discontinued after six years, so neither line will be replaced. Engineering prefers B because it "pays for itself in three years"; finance prefers A because it "creates more value". Discount factors at 12%: year 1 0.893, year 2 0.797, year 3 0.712, year 4 0.636, year 5 0.567, year 6 0.507. The finance director also wants to know how much forecast error the recommendation can absorb.
1. Compute the NPV and payback of each line and recommend one, with reasons.
Read the worked answer
Line A - ₹12,00,000 a year for 6 years; annuity factor at 12% for 6 years = 4.111. PV of inflows = 12,00,000 × 4.111 = ₹49,33,200. NPV = 49,33,200 − 40,00,000 = ₹9,33,200. Payback = 40,00,000 ÷ 12,00,000 = 3.33 years.
Line B - ₹8,00,000 for 5 years plus ₹2,00,000 salvage; 5-year annuity factor = 3.605. PV = (8,00,000 × 3.605) + (2,00,000 × 0.567) = 28,84,000 + 1,13,400 = ₹29,97,400. NPV = 29,97,400 − 24,00,000 = ₹5,97,400. Payback = 24,00,000 ÷ 8,00,000 = 3.00 years.
Recommend Line A. Both projects have positive NPV, so both create value; but they are mutually exclusive and only one can be taken, so the rule is highest NPV. A creates ₹3,35,800 more wealth.
Payback prefers B, and that preference is misleading: payback ignores A's cash flows in years 4 to 6 - ₹36,00,000 undiscounted - which are precisely where most of A's value lies, and it ignores the time value of money altogether. It measures liquidity and risk recovery, not value creation. Engineering's instinct about speed is not wrong as a risk comment, but it is the wrong criterion for this choice.
The unequal lives do not distort matters: the product is discontinued after six years, so Line B's missing sixth year is a genuine economic disadvantage, and no equivalent-annual-annuity adjustment is needed.
2. Estimate the IRR of each line and explain why the IRR ranking conflicts with the NPV ranking.
Read the worked answer
Line A: IRR is where 12,00,000 × annuity(6 years, r) = 40,00,000, i.e. factor 3.333. At 20% the factor is 3.326 (NPV ≈ −₹9,000); at 18% it is 3.498 (NPV ≈ +₹1,97,000). Interpolating: IRR ≈ 19.9%.
Line B: At 20%: (8,00,000 × 2.991) + (2,00,000 × 0.402) = 23,92,800 + 80,400 = ₹24,73,200 → NPV +₹73,200. At 22%: (8,00,000 × 2.864) + (2,00,000 × 0.370) = 22,91,200 + 74,000 = ₹23,65,200 → NPV −₹34,800. Interpolating: IRR ≈ 21.3%.
So B has the higher IRR (21.3% vs 19.9%) but the lower NPV (₹5.97 lakh vs ₹9.33 lakh).
Why they conflict - scale. IRR is a percentage, a return per rupee invested, and is blind to size. B earns a slightly better rate on a much smaller base. Putting ₹40 lakh to work at 19.9% creates more wealth than putting ₹24 lakh to work at 21.3%. The other classic cause of conflict - differing timing of cash flows - is not present here, because both projects have level annual inflows.
Rule: in a mutually exclusive choice, rank on NPV. IRR is still useful as a summary of robustness: A can survive a rise in the cost of capital to about 20% before value disappears. If the capital budget were cut to ₹24 lakh, B would be the only feasible project and would be accepted - the conflict would vanish, which shows that the choice is driven by the budget constraint as much as by the projects.
3. By what percentage can Line A's annual inflows fall before NPV reaches zero? What does the answer indicate?
Read the worked answer
Set NPV = 0: annual inflow × 4.111 = 40,00,000, so the required inflow is ₹40,00,000 ÷ 4.111 = ₹9,72,999. Fall from ₹12,00,000 = ₹2,27,001, i.e. 18.9%. Line A can miss its forecast by nearly a fifth before it destroys value.
For comparison, Line B: required inflow × 3.605 = 24,00,000 − 1,13,400 = 22,86,600, so ₹6,34,286 - a fall of ₹1,65,714, i.e. 20.7%.
Interpretation: B has a marginally wider percentage cushion, but A still creates more value across the plausible range, so the recommendation stands. The sensitivity also tells the finance director where to focus diligence: A's risk sits in six years of volume and price assumptions, and in the year 4-6 cash flows that payback ignores entirely. If both forecasts spring from the same sales estimate, the right test is a single common downside scenario rather than one project at a time - at a 20% shortfall A is roughly at break-even while B remains marginally positive, which is the point at which the two criteria converge.
A practical conclusion: the ranking is robust to a shortfall of up to about 19% in A's inflows, and to a rise in the cost of capital to about 20%. Beyond either limit the decision should be re-tested, not simply reversed.