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 A: Build New Plant

         Year1 Year2 Year3   Year4   Year5   Year6 Year7 Year8 Year9   Year10

Revenue 0     0        0   400     800     800    800   800    800     800

Expense 800    600    600    50      50      50      50    50     50   50

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

I have first answered all your questions sequentially. All back up calculations are there in the table towards the end of the solution.

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

Proposal A = $ 2,850

Proposal B = $ 1,400

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

Proposal A = 6.20 years

Proposal B = 4.91 years

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)

Proposal A = $  2,918.26

Proposal B =  1,888.39

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)

Proposal A = $  2,042.50

Proposal B = $  1,318.29

(You may want to enter these figures with a negative sign as these are expenses or outflows, if required)

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)

Proposal A = $ 875.77

Proposal B = $ 570.10

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

Proposal A = 18.96%

Proposal B = 25.54%

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

Based on profits, project A is recommended. Based on NPV, project A is recommended. Based on payback period and IRR, project B is recommended. When there is a conflict in recommendation, we should resort to recommendation based on NPV. NPV method takes precedence over any other capital budgeting method.  Hence, project A is recommended as it has higher NPV.

Merits:

1. Higher NPV
2. Higher profits
3. Lower maintenance expenses
4. Extra capacity creation for future expansion

Risks:

1. High cash outflow requirements in the first three years
2. More capex intensive
3. Higher gestation period (break even) period
4. Lower IRR
5. Positive cash flows occur later in the project
6. Absolutely no revenues or cash inflows for first three years
7. If project gets stuck due to any reason in first three years, huge capital expenditure will be blocked

Please see the table below. You can also understand the mathematics making use of [+] / [-] sign appearing in the first column. The cells highlighted in yellow contain the answer. Figures in parenthesis, if any, mean negative values. All financials are in $. Adjacent cells in blue contain the formula in excel I have used to get the final output.