A firm has a $100 million capital budge. It is considering two projects that eac

ID: 2650916 • Letter: A

Question

A firm has a $100 million capital budge. It is considering two projects that each cost $100 million. Project A has an IRR of 20 percent, and NPV of $9 million, and will be terminated after 1 year at a profit of $20 million, resulting in an immediate increase in EPS. Project B, which cannot be postponed, has an IRR of 30 percent and an NPV of $50 million. However, the firm’s short-run EPS will be reduced if it accepts Project B, because no revenues will be generated for several years.
a. Should the short-run effects on EPS influence the choice between the two projects?
b. How might situations like this influence a firm’s decision to use payback?

Explanation / Answer

Answer:

Evaluation of Projects

Project A

Project B

Cost

$ 100,000,000

IRR

20%

30%

NPV

$ 9,000,000

$ 50,000,000

Effect on EPS

Immediate increase

Short run reduction

Ans-a:

Effect on EPS can not effect the decision making as decision is taken on the basis of IRR and NPV

Ans-b:

Co. can use the Payback period for evaluation as it would let it know the time period in which the project shall give back the initial cost back.