Question

As we are preparing to use the Figures of Merit to evaluate our team capital investment projects, please discuss the following:

1. What makes a Net Present Value acceptable and why do we use it in project evaluation?
2. What does the Benefit Cost Ratio tell you about a project and how would you explain a BCR of 1.76 as a profitability index?
3. What is the Internal Rate of Return and why do you want a project's discount rate to be lower?
4. How did Nina Sanders revise her project plan in Chapter 7 and why did she make each revision?

Answer 1

Using the net present value (NPV) an investment or a project becomes acceptable when the NPV is positive. We use NPV in project evaluation because it is a capital budgeting tool that represents the net benefit over and above the compensation for time and risk. NPV has a direct linkage with value maximization and hence is used as an absolute measure in case of project evaluation.

The Benefit Cost Ratio (BCR) tells us the proportion of present value of benefits relative to the costs and initial outlays associated with the project. BCR = present value of benefits/Initial investment. So when the BCR is > 1 then the project is accepted and if BCR <1 then the project is rejected. A BCR of 1.76 tells us that the project’s total present value of benefits is equal to 1.76 times the amount spends by it. In other words for every $1 expended by a project it is able to produce $1.76 in the form of benefits in terms of present value.

Internal Rate of Return (IRR) is that discount rate which makes the NPV of a project nil. In other words at IRR: present value of future cash flows = amount of initial investment. We want a project’s discount rate to be lower because for a project to be financially feasible it’s IRR > cost of capital. This is because the rate of return being produced by the project should be higher than its cost of capital (or its hurdle rate).

In Chapter 7, Nina’s project needs to be revised because there are errors in the proposal. The areas of focus to revise are the funds needed for the investment and relevant future cash. Nina also did not include the excess capacity cost because she possibly didn’t know to include it. However, it is important she includes it now because in year 2 another division may plan to use the space she wants for her current division.