Question

In year 0 of project A, your company is required to make $1M investment but in year 1, 2, 3, 4, 5, and 6 the investment level is only $250K per year. Benefits are forecasted to start in year 3 and continue for the next 20 years varying by each year. Breakeven period is somewhere between year 6 and 7. There is another project alternative (call it project B) that is known but not pursued because the payback period is after year 10 and so the current engineering manager assigned to conduct the economic analysis did not consider this alternative. (a) Should the company invest the time and effort in conducting an analysis for the alternative project? Why or Why not? (b) Create a spreadsheet to show a reasonable analysis for the 20-year period. Use numbers provided and make-up numbers that have not been provided to you as part of this question.

Answer 1

(a): Yes, the company should certainly invest the time and effort in conducting an analysis for the alternative project. This is because while the alternate project is less attractive on the payback criteria it may be more attractive on other capital budgeting criteria like NPV analysis or IRR analysis. It should be noted that payback method is not a superior method of capital budgeting as it does not consider the time value of money.

(b): Reasonable analysis for 20 year period for both projects A and B is done below in terms of NPV analysis and assuming the cost of capital to be 10%.

For A:

B:

Thus we can see that in terms of payback project A is attractive while in terms of NPV project B is more attractive. As NPV is a better capital budgeting tool (since 10% cost of capital and time value of money is considered) we can say that project B is superior when compared to project A.