Your company is struggling with an internal investment decision between two proj

Question

Your company is struggling with an internal investment decision between two projects. Assume both projects are independent and mutually exclusive. Your company only has $20 million in its capital budget to invest in just one of these projects. Both projects have an initial investment of the full $20 million. The estimated net cash flows (in millions) for each project are:

                        Year                            Project X                                 Project Y

                           1                                           4                                     2

                           2                                           6                                     3

                           3                                           12                                    8

                           4                                           12 14

                           5                                           12 18

                   

a. What is regular payback period of each project? Which is preferred? Why?

b. What is the discounted payback period for each project? Which is preferred?

c. If the cost of capital for your company is 12% and you use the NPV capital budgeting tool, which project is preferred? Why?

       

d. What do these NPV numbers mean for the value of the firm?

e. Which project

Explanation / Answer

Project X

Payback period = 2+(20-6-4)/12 = 2.83 years

Project Y

Payback period = 3+(20-8-3-2)/14 = 3.5 years

Project X is preferred according to regular payback period because in just 2.83 years it will recover its cost as compared to project Y which will take 3.5 yrs to recover its cost.

b).

discount rate = 12%

Project X

discounted payback period = 3+(20-3.5714-4.7831-8.5413)/7.6262 = 3.407 years

Project Y

discounted payback period = 4+(20-1.7857-2.3915-5.6942-8.8972)/10.2136 = 4.120 years

Project X will be preferred

c).

Project X

NPV = -20+4/1.12+6/1.12^2+12/1.12^3+12/1.12^4+12/1.12^5 = $11.3312 million

Project Y

NPV = -20+2/1.12+3/1.12^2+8/1.12^3+14/1.12^4+18/1.12^5 = $8.9824 million

Project X has more NPV so project X should be chosen as its present worth is more

d).

NPV is net present worth off all the cash flow including the initial outflow, these no indicate that the net present worth of the projects, a project whose NPV is greater than zero should be chosen, but if two projects are mutually exclusive then the project with higher NPV should b chosen

e).

Project Profitability will relatively more improved when company reduce the rate to 8% because in Project X the major part of the cash flow is in the initial years that 4, 6 , 12, 12, 12 but in project Y cash flow is more skewed at the end years so they will have more discount factor, so project X profitability will improve more

year Project X X discounted vaue Project Y Y discounted value 1 4 3.571428571 2 1.785714286 2 6 4.783163265 3 2.391581633 3 12 8.541362974 8 5.694241983 4 12 7.626216941 14 8.897253098 5 12 6.809122269 18 10.2136834

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