Question

Contact Manufacturing, Inc is considering two alternative investment proposals. The first proposal Calls for a major renovation of the company's manufacturing facility. The second involves replacing just a few obsolete pieces of equipment in the facility. The company will choose one project or the other this year, but it will not do both. The cash flows associated with each project appear below and the firm discounts project cash flows at 15%.

Year Renovate Replace

0 -9,000,000 -2,400,000

1 3,000,000 2,000,000

2 3,000,000 800,000

3 3,000,000 200,000

4 3,000,000 200,000

5 3,000,000 200,000

Overall there should be conflicting recommendations based on various criteria. Why is this?

I know that the NVP is making it appear that renovation should take place and IRR is showing replace should take place. Can I get a expert opinion on your thoughts? Which way should they go with the choice?

Answer 1

The rankings provide mixed signals because of the differing cash flow patterns and initial investments of the two projects. Projects that have lower initial investments and return their cash flows earlier in the life of the project tend to have higher IRRs, as is the case with the Replace project.

If we assume that the discount rate of 15 % is the Return what the company wants then
renovation should be recommended as at this point the renovation curve is above than replacment(Plot the NPV of renovation and replacement in excel)

if the return is greater than 15 % say 20% then replacement should be recommended as at this point the replacement curve is above than renovation curve

Replacment has the higher PI and IRR, but Renovation is a larger scale project with a higher NPV. If these mutually exclusive projects are the only ones available and if there is sufficient capital to finance renovation, then it should be accepted because it contributes the most to shareholder value.