Question

New Horizon Heating Systems Limited (NHHSL) is a large publicly listed company and is the market leader in the heat pump manufacturing industry. The company is considering the purchase of one of four mutually exclusive projects for improving its assembly line. The required payback period is three and a half years. The financial data regarding the four projects is given below (ignore taxes).

Project Project A Project B Project C Project D

Sales 80,000 150,000 110,000 90,000

Direct Costs 32,000 54,000 30,000 36,000

Depreciation 16,000 80,000 60,000 70,000

Interest 24,000 32,000 18,000 14,000

Initial Investment 200,000 350,000 180,000 140,000

Project Life (Years) 10 12 16 15

The manufacturing department has requested the board to evaluate these opportunities by means of a discounted cash flow technique. The finance department personnel have been unwilling to use a discounted cash flow technique because of the difficulty in establishing an appropriate discount rate. They, therefore, propose to calculate each project's internal rate of return and let the board determine appropriate hurdle rates. Required:

(a) Calculate each project's payback period and state which alternative should be accepted based on this criterion.

(b) Calculate each project's internal rate of return (IRR), and using a hurdle rate of 22% state which of the opportunities is acceptable by this criterion.

(c) Discuss the possible reasons why the above two project appraisal methods do not give answers which are consistent with each other, for the accept/reject decision. Which should the board employ? Why?

(d) Discuss some of the elements which should be considered when determining the appropriate hurdle rate for an individual project.

Answer 1

		Project A	Project B	Project C	Project D
	Sales	80000	150000	110000	90000
	Direct costs	32000	54000	30000	36000
	Annual operating cash inflow	48000	96000	80000	54000
	Initial investment	200000	350000	180000	140000
	Note: As tax is to be ignored, depreciation is irrelevant as it does not give any
	tax shield. Further, interest expense is to be ignored for evaluation of capital
	expenditure.
a)	Payback period (Years)	4.17	3.65	2.25	2.59
	Evaluation:
	The required payback period is 3.5 years and all projects with payback less
	than 3.5 years are acceptable. Hence, Projects A & B are to be rejected
	outright. But, as all the projects are mutually exclusive, out of Projects C & D
	Project C is to be chosen as it has the lowest payback period.
b)	IRR is that discount rate for which, PV of cash inflows is equal to the initial
	investment.
	Thus, for each project
	Initial investment = Annual operating cash inflow*PVIFA(r,n), where r = the
	projects IRR, and n = the projects life.
	To solve for IRR,
	Initial investment/Annual operating cash inflow = PVIFA(r,n)
	So, PVIFA(r,n)	4.1667	3.6458	2.2500	2.5926
	Life of the project (n)	10	12	16	15
	Lower bound interest rate [%]	21	26	45	39
	Lower bound interest rate annuity factor	4.0541	3.6059	2.2164	2.5457
	Upper bound interest rate [%]	20	25	44	38
	Upper bound interest rate annuity factor	4.1925	3.7251	2.6661	2.6106
	IRR = Lower bound interest rate-(PVIFA(r,n)-Lower bound interest rate factor)/(Upper bound interest rate factor-Lower bound interest rate factor) =	20.19	25.66	44.93	38.28
	Evaluation:
	The hurdle rate being 22%, Projects B,C and D are acceptable. But, as they are mutually
	exclusive, Project C, with the highest IRR is to be preferred.
c)	The reasons are (1) Payback period does not use time value of money, that is does not use
	discounted cash flows, whereas, the IRR uses the discounted cash flow technique.
	(2) The maximum payback period of 3.5 years is arbitrary. In contrast the hurdle rate is
	more rational.
	(3) The payback period does not take into account the cash inflows after the payback
	period, whereas the IRR takes the entire cash inflow stream into account.
d)	Elements to be considered:
	1) The WACC of the firm.
	2) The riskiness of the project in comparison with the exisiting projects, as WACC is
	the hurdle rate for projects that have the same risk as the exisitng investments of the firm.
	If the riskiness of the new projects differ, then adjustments have to be made to increase
	or lower the WACC before it is used as the hurdle rate.