1) A project has a net present value of zero. What does this mean to the company
ID: 2746991 • Letter: 1
Question
1) A project has a net present value of zero. What does this mean to the company?
2) Describe two disadvantages of the payback method for capital budgeting decisions?
3) When comparing mutually exclusive projects, the NPV method is used to ___________.
4) You work for a company whose primary long term financial goal is to undertake projects that maximize company value. You have been asked to provide a recommendation with respect to selecting one of two mutually exclusive projects. The first project has an NPV of $150K and an IRR of 10%. The second has an NPV of $120K and an IRR of $12.5%. Which project should you recommend and why? (Show all work)
5) Your company has identified several independent projects that will add value to the company. Unfortunately, the company has an insufficient capital budget to undertake all of the projects. What general recommendation would you make for selecting the appropriate projects?
Explanation / Answer
1) Net Present Value of Zero means the company neither gains, nor loses money, as compared to the discount rate. Therefore, the company does not gain any money by pursuing the project.
2) two disadvantages of the payback method for capital budgeting decisions are
2.1) it doesn't take into account time value of money.
2.2) it does not consider the cash inflows that happen after the payback period. For two projects, one may have declining and one may have increasing cash inflows after the payback period. So Payback period method fails to make a more accurate quantitative assessment of the projects.
3) When comparing mutually exclusive projects, the NPV method is used to Evaluate and select the best project, which will provide best returns
4) With the given parameters of Project A having a higher NPV, but project B having a higher IRR, we conclude that Project A has some large but delayed cash flows, while Project B has small but early cash flows. In this situation, when we have two mutually exclusive projects, we select the project based on NPV. The reason for the same is that IRR is an arbitrary rate, derived from the premise that NPV = 0. IRR method assues that the cash inflows are reinvested at IRR , whereas NPV method is based on the premise that cash inflows are reinvested at cost of capital. NPV method is preferred over IRR, because, practical discounting rate would be the cost of capital and not the IRR (which is just a theoretical discounting rate). So we should choose the project with higher NPV of $ 150k.
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