The cash flow for projects A.B,C are given below: Year Project A Project B Proje

Question

The cash flow for projects A.B,C are given below: Year Project A Project B Project C 0 -100 -100 -100 1 0 100 0 2 200 0 0 3 -100 100 300 Questions: a) Calculate the payback period and net present value for each project (assuming a 10% discount rate) b) If A and B are mutually exclusive and C is independent, which project, or combination of projects, is preferred using (1) the payback method or (2) the net present value method? What do the results tell you about the value-additivity properties of the payback method?

Explanation / Answer

It is clear that the above project is worthwhile: • Its NPV 0, so that by the NPV criterion the project should be accepted. • Its IRR of 19.71% is greater than the project discount rate of 15%, so that by the IRR criterion the project should be accepted. A General Principle We can derive a general principle from this example: For conventional projects, projects with an initial negative cash flow and subsequent nonnegative cash flows (CF0 < 0, CF1 = 0, CF2 = 0, . . . , CFN = 0), the NPV and IRR criteria lead to the same “Yes–No” decision: If the NPV criterion indicates a “Yes” decision, then so will the IRR criterion (and vice versa). 7.5 Do NPV and IRR Produce the Same Project Rankings? In the previous section we saw that, for conventional projects, NPV and IRR give the same “Yes–No” answer about whether to invest in a project. In this section we see that NPV and IRR do not necessarily rank projects the same, even if the projects are both conventional. Suppose we have two projects and can choose to invest in only one. The projects are mutually exclusive: They are both ways to achieve the same end, and thus we would choose only one. In this section we discuss the use of NPV and IRR to rank the projects. To sum up our results before we start: • Ranking projects by NPV and IRR can lead to possibly contradictory results. Using the NPV criterion may lead us to prefer one project whereas using the IRR criterion may lead us to prefer the other project. 164 PART TWO CAPITAL BUDGETING AND VALUATION 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 A B C D E F G Discount rate NPV 0% 1,100.00

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