A company has budgeted for a capital investment of £150,000. Only one project can be chosen for investment and the company must decide between three different investment proposals. The following information is provided: [12 MARKS]
Answer (b):
NPV, IRR and payback period of all three projects (Project A, Project B and Project C) are calculated and given below:
Answer (c):
Payback period:
Merits of Payback method:
1. It is simple to calculate
2. Its principle of evaluating projects based on how quickly one can recover initial investment works well for risky investments or investments in technology investments where obsolescence rate is high.
Demerits of Payback method:
1. It does not consider time value of money
2. It does not consider cash flows after payback period.
NPV:
Merits of NPV:
1. NPV provides net addition to shareholder value.
2. NPV uses time value of money
3. It factors in cash flows of entire duration of project
Demerits of NPV:
1. When capital is limited and projects have to be ranked for selection, it is essential that initial capital investments are factored in. In such circumstances, instead of NPV, Profitability Index has to be used.
IRR:
Merits of IRR:
1. IRR gives % return on the original money invested.
2. IRR uses time value of money
3. It factors in cash flows of entire duration of project
Demerits of IRR:
1. In quite a few circumstances when cash flows are erratic one may find multiple IRRs of an investment.
2. IRR assumes reinvestment at the rate of IRR
Answer (d):
As only one is to be selected, Project A is recommended for acceptance.
Payback period: No cut off payback period is given. Project C has lowest payback period and Project A is next best.
NPV: Project B has negative NPV and hence has to be rejected. Both project A and C has positive NPV and are acceptable. Since initial investment is same and Project A has higher NPV than that of Project C, Project A is recommended.
IRR: Project B's IRR is less than cost of capital and hence has to be rejected. Both project A and C have IRR greater than cost of capital and hence are acceptable. Since Project A has higher IRR than that of Project C, Project A is recommended.
A company has budgeted for a capital investment of £150,000. Only one project can be chosen...
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