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 of 1000 words. All calculations should be attached in an appendix at the end of your report (and do not form part of the word count).

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%

Using IRR function,Project B IRR ==>40.59%

Using IRR function,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.

-------------------------------

-------------------------------