Explain why project is/is not acceptable. Discussion on NPV, IRR, PI, and payback period.
Clear and incisive analysis of relevant information in capital budgeting models. Developed understanding of key capital budgeting decision criteria.
Competent analysis of relevant information in capital budgeting models. Solid understanding of key capital budgeting decision criteria.
Surface level analysis of relevant information in capital budgeting models. Some understanding of key capital budgeting decision criteria but with significant gaps.
Question 1
The above projects details will lead to the following incremental project related cash flows.
The computation leads to a positive NPV ($0.14 million) which implies that accepting the project would be beneficial for the shareholders (Northington, 2015).
Based on IRR, the project would be accepted since the discount rate applicable for the new plant project is 10% and hence lower than IRR computed (Brealey, Myers and Allen, 2015).
The profitability index computation is executed in line with the formula stated below (Damodaran, 2015).
As the profitability index tends to be cross the hurdle rate of 1, hence the new plant is financially feasible as per this criterion.
Therefore, payback period amounts to 7 + (0.1/0.7) = 7.14 years
This implies that 7.14 years would be taken to recover the initial investment of $ 3 million. But considering that the life of the project is 10 years, a payback period not exceeding the useful life is considered financially viable provided there is no other hurdle rate set by the management (Petty et. al., 2015).
Question 2
NPV computation using 12% as the discount rate yields NPV as $ 79,350 as shown follows.
IRR computation yields resultant value as 20.96% as at this value, the NPV becomes zero as indicated below.
The computations to assist with payback period calculation are as shown below.
Project B
NPV computation using 12% as the discount rate yields NPV as $ 85,478 as shown follows.
IRR computation yields resultant value as 23.92% as at this value, the NPV becomes zero as indicated below.
The inference drawn from above analysis is that project B only is financially viable.
Based on the above, project B is superior and would be given preference over the other project i.e. project A.
Brealey, R. A., Myers, S. C., and Allen, F. (2015) Principles of corporate finance, 2nd ed. New York: McGraw-Hill Inc.
Damodaran, A. (2014). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.
Northington, S. (2015) Finance, 4th ed. New York: Ferguson
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2015). Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French Forest Australia.
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