Your company Portfolio Manager is convening a review board in the first calendar quarter to consider three projects. You have been asked to provide recommendations with respect to the capital budgeting aspects of these projects. Your recommendations will be considered by the review board along with other non-financial aspects of the projects. Initial (year 0) funding will be provided in the current year for the single project selected.
Project sponsors have provided the following estimated cash flow projections:
|
Project A
|
|
|
|
Project B
|
|
|
C
|
|
|
|
Year
|
Outflow
|
Inflow
|
Netflow
|
Outflow
|
Inflow
|
Netflow
|
Outflow
|
Inflow
|
Netflow
|
|
0
|
15000
|
|
-150000
|
15000
|
|
-150000
|
20000
|
|
-200000
|
|
1
|
|
20000
|
20000
|
130000
|
40000
|
-9000
|
150000
|
|
-150000
|
|
2
|
|
30000
|
30000
|
|
50000
|
50000
|
|
90000
|
90000
|
|
3
|
|
40000
|
40000
|
|
60000
|
60000
|
|
100000
|
100000
|
|
4
|
|
40000
|
40000
|
|
90000
|
90000
|
|
110000
|
110000
|
|
5
|
|
50000
|
50000
|
|
90000
|
90000
|
|
120000
|
120000
|
The company has not yet decided how the selected project will be financed. The cost of capital or hurdle rate will vary depending upon how the company decides to finance the project. You decide to compare projects in three areas: (1) payback period (not considering the cost of capital); NPV sensitivity (see note 1 below); and (3) Internal Rate of Return (IRR). Conduct each analysis and interpret the results.
Based on your analysis, which project would you recommend and why? Your recommendation must be based on the combination of all three factors.
Show all calculations supporting your recommendation. Calculate NPV to the nearest dollar, IRR to three decimal places, and payback period to one decimal place.
Note 1: Project NPV varies inversely with the cost of funds to perform the project (expressed as the hurdle rate or k in the NPV discount factor formula). Some project NPVs are more sensitive to changes in k than others. See the NPV Profile discussion in Gallagher, Chapter 10, pages 278-279 (Reserved Readings) for information on determining NPV sensitivity.
NPV Calculations
The NPV Profile The k value is the cost of funds used for the project. It is the discount rate used in the NPV calculation because the cost of funds for a given project is that projectAc€?cs required rate of return. The relationship between the NPV of a project and k is inverseAc€??the higher the k, the lower the NPV, and the lower the k, the higher the NPV.3 Because a projectAc€?cs NPV varies inversely with k, financial managers need to know how much the value of NPV will change in response to a change in k. If k is incorrectly specified, what appears to be a positive NPV could in fact be a negative NPV and vice versaAc€??a negative NPV could turn out to be positive. Mutually exclusive project rankings could also change if an incorrect k value is used in the NPV computations.4 To see how sensitive a projectAc€?cs NPV value is to changes in k, analysts often create an NPV profile. The NPV profile is a graph that shows how a projectAc€?cs NPV changes when different discount rate values are used in the NPV computation. Building an NPV profile is straightforward. First, the NPV of the project is calculated at a number of different discount rates. Then the results are plotted on the graph, with k values on one axis and the resulting NPV values on the other. If more than one project is included on the graph, the process is repeated for each project until all are depicted. To illustrate, we will build an NPV profile of Projects X and Y. We will plot Project X and then Project Y on the graph. To begin, we first calculate the NPV of Project X with a number of different discount rates. The different k values may be chosen arbitrarily. For our purposes, letAc€?cs use 0 percent, 5 percent, 10 percent, 15 percent, and 20 percent. The results of Project XAc€?cs NPV calculations follow: Discount Rate Project X NPV 0% $500.00 5% $ 57.77 10% Ac€?o$326.82 15% Ac€?o$663.68 20% Ac€?o$960.65 Now Project XAc€?cs NPV values may be plotted on the NPV profile graph. Figure 10-1 shows the results. When the data points are connected in Figure 10-1, we see how the NPV of Project X varies with the discount rate changes. The graph shows that with a k of about 5.7 percent, the value of the projectAc€?cs NPV is zero. At that discount rate, then, Project X would provide the firmAc€?cs required rate of return, no more and no less. Next, we add project Y to the NPV profile graph. We calculate the NPV of Project Y at a number of different discount rates, 0 percent, 5 percent, 10 percent, 15 percent, and 20 percent. The results follow: