A project analyst estimates that a proposed project will have an expected return

Question

A project analyst estimates that a proposed project will have an expected return of 16%, which is higher than the Minimum Acceptable Rate of Return demanded by the corporation. He decides to also conduct a study of the uncertainties of a project and arrives at the conclusion that the project will have the following possible returns:

The analyst submits his recommendation to the board that the project should not be undertaken, even though it is expected to provide a return greater than the MARR. Why do you think that this might be the case? Under what conditions this decision might be warranted? Under what conditions might the analyst's position be overturned?

Explanation / Answer

The expected rate of return is calculated as the internal rate of return.

If the project that is undertaken has unconventional cash flows, that is both positive and negative cash flows throughout the period of the project, then there would be multiple rates of returns and hence the rate of return of 16% may not be accurate. Under this condition, the decision not to undertake the project is correct

However, if the project has convention cash flows, that is an initial investment followed by a series of cash inflows, then the rate of return is correct and the project can be accepted. In addition, the NPV of the project can also be calculated to confirm the same. In this case, the decision can be overturned.

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