Question

Elon Musk has asked for your advice. Should he invest $1 billion into his SpaceX company to develop a Mission to Mars – or should he invest in a second giant battery factory in Nevada? For these two projects, which should he look at, NPV or IRR? In other words, generally speaking, what are their positives and negatives and which may be more relevant to his situation? Also, what is WACC and how should he think about it in terms of financing of these projects? At this point, you don’t know what the IRR or NPV or WACC are, but what Musk is asking you is more of a sense of what these are and how they may be relevant to his way of thinking.

Answer 1

Elon Musk should take decision based on NPV. Whenever there is a conflict between NPV and IRR, the project with the higher NPV should be chosen. This is because IRR assumes that all cash flows would be reinvested at the IRR. This assumption is problematic because there is no guarantee that equally profitable opportunities would be available as soon as the cash flows occur.

Positives of NPV:-

- Unlike IRR, NPV doesn't assume that the cash flows would be reinvested at the project's rate of return

- It is a good measure of profitability of a project.

- It takes into account each and every cash flows over the period.

Negatives of NPV:-

- It ignores sunk costs. Sunk costs are the costs which you incur before starting the project - these costs which may sometimes be very huge are ignored.

- Sometimes the managers are too optimistic about the project and therefore, the cash flows projected are too high. Therefore, this method can be biased upward.

Positives of IRR:-

- It is simple and easy to understand

- This method doesn't require the hurdle rate. Projects can be selected where the IRR exceeds the estimated cost of capital.

Negatives of IRR:-

- It does not account for the project size when comparing projects. This can be troublesome when two projects require a significantly different amount of capital outlay, but the smaller project returns a higher IRR. For example, a project with a $100,000 capital outlay and projected cash flows of $25,000 in the next five years has an IRR of 7.94 percent, whereas a project with a $10,000 capital outlay and projected cash flows of $3,000 in the next five years has an IRR of 15.2 percent. Using the IRR method alone makes the smaller project more attractive, and ignores the fact that the larger project can generate significantly higher cash flows and perhaps larger profits

- It makes an implicit assumption that the cash flows would be reinvested at the IRR. This assumption is not practical because IRR is sometimes very high and opportunities that generate such high returns are generally limited.

WACC is the average rate of return a company expects to compensate all its investors including debt, equity, etc. Musk should arrive at the capital structure which has the lowest WACC