Question

You are a senior manager at Airbus and have been authorized to spend up to €200,000 for projects. The three projects you are considering have the following characteristics:

Project A: Initial investment of €158,000. Cash flow of €52,000 at year 1 and €108,000 at year 2. This is a plant expansion project, where the required rate of return is 9 per cent.

Project B: Initial investment of €200,000. Cash flow of €200,800 at year 1 and €113,000 at year 2. This is a new product development project, where the required rate of return is 19 per cent.

Project C: Initial investment of €104,000. Cash flow of €104,400 at year 1 and €102,000 at year 2. This is a market expansion project, where the required rate of return is 19 per cent. Assume the corporate discount rate is 9 per cent.

Required; Please offer your recommendations following your investment appraisal using Payback period, IRR, Incremental IRR, PI and NPV backed by your analysis

Answer 1

1). NPV analysis:

NPV = sum of all cash flows discounted at the project required return

Project A = -158,000 + 52,000/(1+9%) + 108,000/(1+9%)^2 = -19,392.14

Project B = -200,000 + 200,800/(1+19%) + 113,000/(1+19%)^2 = 48,536.12

Project C = -104,000 + 104,400/(1+19%) + 102,00/(1+19%)^2 = 55,759.90

On the basis of NPV, Project A should be rejected as it has a negative NPV so it is loss making. Either Project B or Project C can be chosen since both have positive NPVs.

2). IRR analysis:

Using IRR function,

Project A IRR = 0.75%

Project B IRR = 40.59%

Project C IRR = 61.22%

On the basis on IRR, again Project A is rejected as its IRR is less than the required return of 9%. Other two projects have IRR greater than the respective required return so either can be chosen. Based solely on IRR, Project C should be chosen as it has the highest IRR out of the three projects.

3). Payback period analysis: It is the time period required for a project to break-even or in other words, to recover its initial investment.

Project A payback period = 1.98 years

Project B has a payback period of (200,000/200,800) = 0.996 years (its CF1 ia greater than its initial investment CF0 so it breaks even under one year's time.)

Project C payback period is (104,000/104,400) = 0.996 years (same case as Project C).

Projects B and C have shorter payback period than Project A so either can be accepted based only on the payback period criteria.

4). Incremental IRR analysis:

We start with arranging the projects in the ascending order of initial investments, so we get C, A , B.

First we compare C and A by taking the cash flows of (A-C) and calculating the IRR.

We find that the IRR of (A-C) cannot be calculated as the cash flows are such that the project will not break even at any discount rate. We calculate the NPV of (A-C) at the corporate required return (MARR) of 9% to get an NPV of -97,023.31. This tells us that the IRR will be less than MARR which is why NPV at MARR is negative. So, Project A (higher investment) is rejected and Project C is accepted.

Next, we compare Project C with Project B, to get cash flows (B-C) and compute the IRR to compare with the MARR. IRR of (B-C) is 10.76% (higher than MARR) so Project B is accepted and Project C is rejected.

Thus, on the basis of incremental IRR, Project B should be accepted.

Calculations: