Question

1) You are considering two possible projects (Project A and Project B) that would start at the beginning of 2020.  Your boss has indicated that she only wants to select one of these projects given resource constraints and uncertainties about the economy.  She has asked you to evaluate each project and recommend which project you think the company should select.   

You have made the following forecasts for each project.  Project A would require an initial investment of $6.4M (USD) on January 1, 2020 and a second investment of $4M on Jan 1, 2021.  The project would break even in the following year (2022) but would earn positive returns of $1.2M, $3.5M, $7.1M, and $12.6M in the following four years.    

Project B would require an initial investment of $18M on January 1, 2020 but would not earn (or cost) anything until the end of 2024 when you think it would return approximately $45M.  

You estimate that an appropriate annual discount rate is 14 percent based on your company’s future projected performance.  Furthermore, the CFO has indicated that there is an inflation rate of 2.5 percent that should be factored into your calculations; he feels that this rate will be fairly constant over the foreseeable future.  The CFO has also indicated that the company uses discrete discounting and assumes that all cash flows occur at the end of each year (except for the initial investments).

Your boss indicated that you should consider the inflation rate adjusted NPV, the IRR, and the Profitability Index when comparing these two projects.  Based on these metrics, which project would you recommend?  What other factors (other than these metrics) might be important when comparing these projects?  How would your company’s risk tolerance impact the possible decision?

Answer 1

Inflation adjusted NPV, IRR and Profitability index of the projects are as follows:

Metric	Project A	Project B
Inflation adjusted NPV	$1.1738 Million	$6.4292 Million
IRR (using IRR function of Excel)	19.274914%	25.743343%
Profitability Index (PI)	1.058392	1.357176

Details of calculation as follows:

,

4 fx =SUM(E7:113) А B C D E F G H i Note: Discount rate employed is Rate based on past performance plus inflatio rate ie., 14% +2.5% = 16.5% All amounts in $ Million 3 Discount rate (r= 16.50% Year PVIF Project Project B (t) =1/(1+r)^t Cash Flow PV Cash Flow PV (CF) CF*PVIF (CF) =CF*PVIF 7 Initial Investment -6.40 -6.4000 -18.00 - 18.0000 8 Additional investment 1 0.8583691 1 0.8583691 -4.00 -3.4335 0.00 0.0000 9 Cash flows 2 0.7367975 0.00 0.0000 0.00 0.0000 10 Cash flows 3 0.6324442 1.20 0.7589 0.00 0.0000 11 Cash flows 4 0.5428706 3.50 1.9000 45.00 24.4292 12 Cash flows 5 0.4659833 7.10 3.3085 13 Cash flows 6 0.3999857 12.60 5.0398 14 Sum of PVs of cash flows 11.0073 24.4292 15 NPV = Sum of PVs of cash flows - PVs of investments 1.1738| 6.4292 16 Profitability index = Sum of PVs/Initial Investments 1.0583924 1.3571764 17 IRR 19.274914% 25.743343% 18

5 ED D17 - fc IRR(07:013) А B D E F G H i Note: Discount rate employed is Rate based on past performance plus inflatio rate ie., 14% +2.5% = 16.5% 2 All amounts in $ Million 3 Discount rate (r)= 16.50% Year PVIF Project A Project B (t) =1/(1+r)^t Cash Flow PV Cash Flow PV (CF) =CF*PVIF (CF) =CF*PVIF 7 Initial Investment 0 -6.40 -6.4000 -18.00 -18.0000 8 Additional investment 1 0.8583691 -4.00 -3.4335 0.00 0.0000 9 Cash flows 2 0.7367975 0.00 0.0000 0.00 0.0000 10 Cash flows 3 0.6324442 1.20 0.7589 0.00 0.0000 11 Cash flows 4 0.5428706 3.50 1.9000 45.00 24.4292 12 Cash flows 5 0.4659833 7.10 3.3085 13 Cash flows 6 0.3999857 12.60 5.0398 Sum of PVs of cash flows 11.0073 24.4292 15 NPV = Sum of PVs of cash flows - PVs of investments 1.1738 6.4292 16 Profitability index = Sum of PVs/Initial Investments 1.0583924 1.3571764 17 IRR 19.274914% 25.743343% 18 19

4 fic =E14/(D7+D8)*-1 B C D E F G H 1 Note: Discount rate employed is Rate based on past performance plus inflatio rate ie., 14% +2.5% = 16.5% All amounts in $ Million 3 Discount rate (r= 16.50% Year PVIF Project Project B (t) =1/(1+r)^t Cash Flow PV Cash Flow PV (CF) CF*PVIF (CF) =CF*PVIF 7 Initial Investment -6.40 -6.4000 -18.00 - 18.0000 8 Additional investment 1 0.8583691 -4.00 -3.4335 0.00 0.0000 9 Cash flows 2 0.7367975 0.00 0.0000 0.00 0.0000 10 Cash flows 3 0.6324442 1.20 0.7589 0.00 0.0000 11 Cash flows 4 0.5428706 3.50 1.9000 45.00 24.4292 12 Cash flows 5 0.4659833 7.10 3.3085 13 Cash flows 6 0.3999857 12.60 5.0398 14 Sum of PVs of cash flows 11.0073 24.4292 15 NPV = Sum of PVs of cash flows - PVs of investments 1.1738 6.4292 16 Profitability index = Sum of PVs/Initial Investments 1.05839241 1.3571764 17 IRR 19.274914% 25.743343%

Other metrics useful for comparing the projects are Pay back period and Benefit Cost Ratio.

The above metrics measure return from the project. Risk is factored in the form of discount rate for calculation of NPV. Going by the rate of return and profitability, project B is to be selected. However, this project needs much higher investment of $18 Million compared to $10.40 Million for project A. Also, the cash flow from project B will commence only late, four years after ionvestment. This increases the risk profile not reflected in the rate of return. For these reasons, project A is preferred over project B.