main objective behind all financial management decisions is to maximize the
value to the stakeholders and optimize the risk-return aspects of the business
portfolio. In this case, the company is confronted with 3 potential projects.
Projects X and Y have similar characteristics with the only difference of
buying (in project X) and leasing (project Y). Project Z seeks to minimize the
initial investment and hence the commitment of funds to the project.
first rule applied is the payback period. This metric is lowest for project Z
as it has payback of 2 years only while the other projects have payback periods
of greater than 4 years. As such, project Z appears the best option. However,
this method does not consider the time value of money and is not highly
informative. The second method of accounting rate of return also implies that
project Z is the best as its return is highest at 44% while the other 2
projects have returns of less than 25% however similarly ignores the time value of money and does not consider the increased risk
of long-term projects.
Net Present Value (NPV) method is then applied as it considers this time value
of money and all the cash flows associated with the project. As per this
metric, project X is the best as its NPV of 22,404 is the highest. However, it
is also important to consider that the initial investment of all the 3 projects
are different. Therefore, the profitability index was computed which expresses
the net present value as proportion of the initial investment. The
profitability index was highest for project Z at 2.23 while it was less than 1
for both projects X and Y with values of 0.66 and 0.58 respectively. As such,
it is suggested that project Z is the best option.
Internal Rate of return (IRR) metric was also used to evaluate the projects and
the highest value was obtained for project Z at 55%. This is much higher than
the required return of 11.5% and therefore project Z is the best option. The
biggest problem with this method is that it assumes that all the cash flows are
invested at this rate and achieving this high return may be impossible for the
company on all intermediate cash flows.
short, it is concluded that project Z is the best project amongst these three
mutually exclusive projects as it has the highest ranking on the basis of all
metrics. Sensitivity analysis was conducted by varying the discount rate and the
results were obtained the same as project Z generated positive net cash flow
till rates as high as 55%. Apart from the financial numbers, the project seems
to commercially sound since it optimizes the use of existing space and minimal
upfront investment which reduces the risk of the company. However, it is
important to note that the recommendations of this report highly depend on the
accuracy of the inputs. If the cash flow pattern differs from the assumptions
made, the profitability of the projects can vary significantly.