The firm faces an exciting task: evaluating two investment projects, Y and Z, for potential inclusion in their portfolio. To navigate this decision effectively, we’ll analyze their viability using NPV, IRR, and payback period calculations under different discount rates.
a) Net Present Value (NPV) at 9% Discount Rate:
Based on NPV, project Z, with an NPV of $5,461.01, appears more attractive than project Y with an NPV of $4,985.22.
b) Impact of Changing Discount Rate:
If the discount rate increases to 15%, the NPVs for both projects will decrease:
However, project Z still maintains a higher NPV at both discount rates, suggesting its relative advantage compared to Y.
c) Internal Rate of Return (IRR):
Since both projects have IRRs exceeding the 9% hurdle rate, they are both potentially good investments. However, Z’s higher IRR implies its cash flows are discounted at a higher rate, indicating a potentially “better” investment from a return perspective.
d) Payback Period:
Both projects have payback periods shorter than the desired limit of 2 years, making them both desirable from a liquidity perspective. Project Z, with a slightly shorter payback period, emerges as the faster cash-generating option.
e) Critically Discussing the Metrics:
Each metric offers a unique lens for evaluating projects:
- NPV: Considers the time value of money and discounts future cash flows to present value. A positive NPV suggests the project creates financial value.
- IRR: Identifies the discount rate at which project’s NPV equals zero. Higher IRR implies greater return potential compared to other investments with the same risk.
- Payback Period: Indicates how quickly the initial investment is recovered through cash inflows. Shorter payback periods suggest lower risk and quicker liquidity.
Choosing the “Right” Project:
Choosing between Y and Z requires a holistic approach, considering all metrics and aligning them with the firm’s specific priorities. While Z has higher NPV, IRR, and payback period advantages, factors like strategic fit, risk tolerance, and availability of funds should also be considered. A detailed discussion with stakeholders considering these additional factors would be crucial before making the final decision.
Remember, these metrics are tools, not absolutes. A comprehensive analysis, including sensitivity analysis under different scenarios, and qualitative considerations are essential for informed investment decisions.
