Question

Capitol Budgeting and Risk Analysis, From the e-Activity, analyze the reasons why the short-term project that you have chosen might be ranked under the NPV criterion if the coat of Capital is high, while the long-term project might be deemed better if the cost of Capital is low. Determine whether or not changes in the cost of Capital could ever cause a change in the internal rate return (IRR) ranking of two projects. From the scenario, take a position for or against TFC's decision to expand to the West Coast. Provide a rationale for your response in which you cite at least (2) capital budgeting techniques, (e.g., NPV, IRR, Payback Period, etc.). that you used to arrive at your decision.

Answer 1

In a short term project with a high cost of capital, the effect of discounting in later cash flows is lesser as compared to longer duration project wherein because of a larger number in the exponent, the discounting factor becomes larger and hence the present value of the cash flow becomes smaller. In a short duration project, the discounting factor does not become large enough to nullify the present value of future cash flow. Thus the short term project would be ranked higher for higher cost of capital.

For a long duration project with a lower cost of capital, the discounting factor does not play a significant part even for cash flows in the distant future and thus a longer duration project can end up with a better NPV.

For the TFCs project the cash flows are as follows:

Year                 0          1          2          3          4          5

CF (million)     -750     -10       200      250      300      400

The discount rate is 10.92%.

So the NPV of the project is $ 23.16 million and the IRR of the project is 11.84% which is greater than the discount rate.

Since NPV is positive which means it adds value to the firm and also IRR greater than hurdle rate, so the decision to go ahead with the project was a correct one.