Question

Year Project A Expected Cash Flows ($) 0 (1,250,000) 1 75,000 2 218,750 3 535,000 4 775,000 5 775,000 Year Project B Expected Cash Flows ($) 0 (1,050,000) 1 650,000 2 500,000 3 226,250 4 137,500 5 62,500 Metrics Payback Period (in years) (A)3.54 (B)1.8 Discounted payback period (in years) (A)4.58 (B)2.72 Net Present Value (NPV) (A)$160,816 (B)$151,742 Internal Rate of Return (A)18.90% (B)23.84% Profitability Index (A)1.13 (B)1.14 Modified Internal Rate of Return (MIRR) (A)17.82% (B)18.15% a). What are some approaches that can be used to solve this problem. b). What are some various criteria or metrics that can be used to help make a decision. c). Rank the projects based on each of the following metrics: Payback period, Discounted payback period, NPV,IRR, Profitability Index and MIRR

Answer 1

A. The solution to this problem varies from analyst to analyst/Comapny to company. However, there is no set of rules to follow in cases like these,but there are certain guidelined to follow.

B. First of all, Both of these projects are profitable and would be taken up by a company if they aren't mutually exclusive.

In case they are mutually exclusive, then i as a decision maker would go for Project A (Which again might differ from analyst to analyst or company to company)

The reasons behind this is -

1. The payback and discounted payback period for project B Is lower than project A. Which would make you choose project B. But if you remember the drawbacks of these two methods, they tend to ignore the cash flows after the discounted payback period is reached. Which (cash flows after PP/DPP are significantly higher in project A than project B, Considering a little difference in the initial investment).

2. NPV/IRR/MIRR - Coming to the main indicator. NPV for project A is significantly higher than project B and there is a very little difference between the intial outlays of the projects which takes away one of the big drawbacks of NPV.

PI again is not a really good measure of profitability in project, and is only marginally higher in project B.

Coming to IRR/MIRR, yes they are higher for project B. But as we are taught that we have to always chose NPV against IRR in case of conflicting results. I would suggest choosing Project A.

C.

The one highlighted in green colour is the better than other

As you can see the image all the methods of capital budgeting are in favour of project B, Except NPV. But still NPV is the best way to analyst a project given that the initial cash outlays lie on the same/similar scale.