Question

You have been hired as a project management consultant to assist the Acme Company in evaluating two different project proposals they are considering. Proposal A calls for the construction of a new plant which will require three years to complete and will have much greater capacity than the old plant. Because the plant will have to be built on the current site, the old plant will have to be razed. Proposal B involves the renovation of this plant. This renovation will require two years to complete, but the plant can remain in operation in a reduced capacity during this upgrade. Once the renovation is complete revenue will be increased by 25% per year, however annual maintenance will be 50% higher than Proposal A.

Proposal B: Renovate Existing Plant

        Year1   Year2 Year3 Year4 Year5   Year6 Year7 Year8 Year9 Year10

Revenue 100   100   350     350    350     350    350   350    350    350

Expense 500   500   75      75     75      75     75    75     75      75

Questions:

a.   What is the profit associated with the project carried out in Proposal A? Proposal B?

b.   When does payback occur on the project carried out in Proposal A? Proposal B?

c.   What is the present value of revenue for the project carried out in Proposal A? Proposal B? (In computing present value, do not discount the value for the first year being examined.) (Assume i = 0.10)

d.   What is the present value of expense for the project carried out in Proposal A? Proposal B? (In computing present value, do not discount the value for the first year being examined.) (Assume i = 0.10)

e.   What is net present value for the project described in Proposal A? Proposal B? (In computing present value, do not discount the value for the first year being examined.) (Assume i = 0.10)

f.    What is the internal rate of return for the project described in Proposal A? Proposal B?

g.   Which project would you recommend? Why? What are the merits? What are the risks?

Answer 1

What is the profit associated with the project carried out in Proposal A? Proposal B?

Profit in Proposal A = Total Revenue – Total Expense (5,200 - 1750) =   3450.00

Profit in Proposal B = Total Revenue – Total Expense (3,000 – 1,600) = 1,400.00

When does payback occur on the project carried out in Proposal A? Proposal B?

Payback occur in Year 7 in Proposal A i.e. Revenue – Expense = 2,800 – 2,700 = 100.00

In Proposal B, payback occur in Year 4 i.e. (Revenue – Expense = 1,250 – 1,150 = 100.00)

What is the present value of revenue for the project carried out in Proposal A? Proposal B? (In computing present value, do not discount the value for the first year being examined.) (Assume i = 0.10)

To calculate the Present Value for the project carried out in Proposal A, we employ the formula, PV = c/(1+i)ⁿ where C is the future amount of money is expected out of the project, n is the number of compounding periods, and I is assumed to be 0.10

P for proposal A =3450/(1+0.1)⁹ =1,463.1 the interpretation is that for an effective annual interest rate of 10%, Acme Company would be indifferent to receiving 3450 in 9 years, or 1,463.1today

To calculate the Present Value for the project carried out in Proposal A, we employ the formula, PV= = c/(1+i)ⁿ where C is the future amount of money is expected out of the project, n is the number of compounding periods , and I is assumed to be 0.10

PV for Proposal A = 1400/(1+0.1)⁹=593.7 the interpretation is that for an effective annual interest rate of 10%, Acme Company would be indifferent to receiving 1400 in 9 years, or 593.7 today

Which project would you recommend? Why? What are the merits? What are the risks?

I recommend that the proposal for system A be adopted, this is because, and its IRR is greater than the cost of capital. The merit of Proposal B is that it will enable the company to evaluate an investment in a new proposal versus an extension of an existing plant based on the IRR of each project. In such a case, each new capital project must produce an IRR that is higher than the company’s cost of capital. Once this hurdle is surpassed, the proposal with the highest IRR would be the wiser investment, all other things being equal, including risk

The biggest risk is that with the IRR, the initial investment amount of money in size is ignored, and therefore the actual cash one receives is a result of their investment. Also, there’s the risk that IRR doesn’t always equal the return on your initial investment over the holding period. When periodic cash flows exist in an investment that results in capital recovery, the IRR makes no assumptions about what is done with the interim cash flows. For instance, the company might put that cash flow into a bank account with a much lower yield than the IRR, which can be problematic when evaluating the true return for an investment.