- In accordance with the information provided, it is apparent that $ 3 million is the initial investment. Also, based on the information provided in relation to the expected cash inflows along with the scrap value at project end, the following summary can be drawn.
- Using the discount as 10%, the NPV of the given project is computed in the tabular manner highlighted as follows.
Considering that project NPV is positive ($0.14 million), therefore the project should be accepted as it would result in value creation for the shareholders (Damodaran, 2014).
- The discount rate at which NPV value becomes zero is called IRR and the relevant computation is highlighted below.
The project IRR is 11.04%. It is greater than the project’s cost of capita and hence it may be derived that the project is feasible in accordance with IRR criterion (Petty et. al., 2015).
For computing the profitability index, the following formula can be used (Brealey, Myers and Allen, 2015).
In case of the project, initial investment required is $ 3 million
Also, the future cash inflows over the project useful life have a present value of $ 3.14 million.
Therefore, PI= (3.14/3) = 1.047
Considering the value of PI exceeds one, the financial feasibility of the project is reflected.
- The amount of time that is required to recoup the starting investment is referred to as the payback period.
The payback period can be computed with the help of the table illustrated below.
Based on the above, it is apparent that the payback period would be 7 + (0.1/0.7) or 7.14 years
Since the payback period associated with the project is lower than the project life, therefore acceptance of project must be done. A key issue with the usage of payback period is that it fails to take into consideration the pivotal concept of time value of money and thereby is taken to be less accurate in terms of capital budgeting decision making (Damodaran, 2014).
- Project A
From the above computation, IRR = 20.96%
Payback Period Table
From the above table, payback period is computed as 3 + (50000/125000) or 3.4 years
From the above computation, IRR = 23.92%
Payback Period Table
From the above table, payback period is computed as 2+ (75000/100000) or 2.75 years
- A key criterion is with regards to NPV being positive which is fulfilled by both projects. Also, both projects have respective IRR greater than the applicable discount rate or cost of capital of 12%. However, it is also required that the payback period of the project must not exceed 3 years which is not fulfilled by Project A but fulfilled by Project B.
In wake of the above discussion, the acceptable project would be project B only.
- With regards to ranking, project B would prove to be superior to project A on account of the reasons indicated below (Brealey, Myers and Allen, 2015).
- NPV (Project B) > NPV (Project A)
- IRR (Project B) > IRR (Project A)
- Payback Period (Project A) > Payback Period (Project B).
Therefore, if only one project could be selected, it has to be project B and not 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.
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.