Final answer:
Openseas should consider proceeding with the investment if the NPV is positive and the IRR exceeds the cost of capital. The investment decision should take into account the potential to invest more due to positive externalities and societal returns beyond the initial cost of $70.7 million.
Step-by-step explanation:
Understanding NPV and IRR
When considering whether Openseas should proceed with a purchase of $70.7 million with a cost of capital at 122%, the first step is to prepare an NPV profile of the investment. The NPV, or Net Present Value, informs us by how much the investment's inflows exceed its outflows, adjusted to the present value using the cost of capital. An investment should only be undertaken if the NPV is positive, indicating that it is expected to generate a profit rather than a loss.
For the Internal Rate of Return (IRR), this is the rate at which the NPV of an investment equals zero. On a graph, the IRR can be found where the NPV profile crosses the x-axis. As per the information given, let's consider that the initial investment is $102 million, which means the project cost has been upscaled from the preliminary value of $70.7 million.
If we take into account the cost of financial capital being 9% and the firm being able to invest as if the effective rate of return is 4% due to capturing an additional 5% return to society, the firm would optimally invest $183 million. Bearing in mind the spillover benefits, if Openseas could internalize the full benefits of its investment, it should be willing to invest more than the initial cost given the positive externalities.
In terms of decision-making, the purchase decision rests on whether the expected return exceeds the company's cost of capital. As such, if Openseas' cost of capital estimate could differ, it would still be worthwhile to proceed with the purchase as long as the NPV remains positive and the IRR exceeds the actual cost of capital.