Question

Oxford Company has limited funds available for investment and must ration the funds among four competing projects. Selected information on the four projects follows:

Project	Investment Required	Net Present Value	Life of the Project	Internal Rate Of Return (Percent)
A	$160,000	$44,323	7	18%
B	$135,000	$42,000	12	16%
C	$100,000	$35,035	7	20%
D	$175,000	$38,136	3	22%

The net present values above have been computed using a 10% discount rate.

The company wants your assistance in determining which project to accept first, second, and so forth.

REQUIRED: In this problem you are asked to rank the projects based on net present value (NPV), then internal rate of return (IRR), then profitability index (PI). Complete the following questions. Clearly identify each one in your response.

1. Describe each method briefly, in one paragraph each. Include how each method is computed and indicate any assumptions made by that method. Start with NPV, then IRR, then PI.

2. What is your evaluation of each method? Start with NPV, then IRR, then PI.

Answer 1

Answer:

1. Description of each method:

NPV(Net Present Value) Method: In this method, net present value of the investment is considered to accept or reject the project. It is also known as Discounted Cash Flow Method as it takes into account the time value of money to calculate the present value of cash inflows and outflows is calculated.

Calculation:

Net Present Value is the difference between the present value of cash inflows and outflows. It may be positive, negative or zero. If difference is positive and zero, then project is accepted and if the difference is negative, then the project is rejected.

Assumptions of NPV Method:

1. The cash generated by a project is immediately reinvested to generate a return at a rate that is equal to the discount rate used in present value analysis.
2. The inflow and outflow of cash other than initial investment occur at the end of each period.

Internal Rate of Return Method: In this method of capital budgeting which gives the rate of return earned in a project. It is the discounted rate of return where Net Present Value is "zero" i.e. difference between the present value of cash inflows and outflows is nil.

Calculation:

IRR = Cash Inflows/(1+r)i - Cash Outflows where r = discount rate and i = time period of project.

A project is acceptable if IRR of the project > cost of capital of the project.

Assumptions of IRR Method:

1. Discount rate does not change over the life of the project.
2. The cash flows generated each year is reinvested in the same project at the calculated IRR.

Profitability Index Method: In this method, a ratio is calculated by dividing the present value of future cash inflows by initial investment in the project. The profitability index is a ratio that shows how much profit results from a project per $1 of initial cost. A project is acceptable if the ratio comes out to be 1 or more than 1. In case of mutually exclusive projects, a project with higher PI ratio is accepted.

Calculation:

PI = Present Value of Expected Cash Inflows/Initial Cost

Assumptions of PI Method:

Profitability index assumes that the cash flow calculated does not include the investment made in the project, which means PI reinvestment at the discount rate as NPV method.

2. Evaluation of each method:

NPV: This is considered as the best method of capital budgeting as it considers the time value of money. NPV estimates a company's future cash flows of the project. It then discounts them into present value amounts using a discount rate representing the project's capital costs as well as its risk.

IRR: IRR does not take into consideration the duration of the project as it would be incorrect to choose the project with highest IRR between two projects having different duration.

PI Method: There are many disadvantages with this method as there is difficulty in calculating the required rate of return and cannot be used when the lives of the different project varies.

As in our case, duration of projects varies, analysing the above shortcomings of the three methods, one should go with NPV method of capital budgeting.