PROFESSIONAL ASSIGNMENT 4
Student Name: Manoj Kumar Reddu Koluguri
Professional Assignment Question #1
At 11 percent cost of capital and unlimited access to capital, the company should go for projects B and C. This is because they have a positive NPV at 11%, a relatively higher IRR and a greater payback of more than one year. Consequently, at 16 percent, Projects B and C are still feasible for the firm to invest in given that its resulting NPV and IRR is higher than WACC with a payback period higher than 1 year.
Where the company is financially limited, then the most feasible project to go for is project B at 11% WACC. The primary reason why the company should select project B is due to its highest NPV, IRR, and greater payback period than projects A and C.
Payback periods for the three projects are; A – 3, B – 2 and C – 3.
From the calculations based on the payback period, project B will have the quickest Return on Investment (ROI) with only two years. However, recommendations based on the payback period are often not consistent with those of NPV. The payback period only relies on returns on investment. Therefore, projects B and C are feasible based on NPV since they have a positive NPV (Marchioni & Magni, 2018) but under the payback project, C will not be feasible.
IRR for the three projects are; A – 0%, B – 76.14% and C – 25.20%.
Using IRR gives the same results as NPV where projects B and C will be selected because they have higher IRRs than WACC. However, in some instances, results between the two might differ depending on the cash flows.
PI (A) = Initial investment + NPV / Initial Investment
= 5,000 – 1,093.90 / 5,000
= 3,906.10 / 5,000
PI (B) = 1,000 + 3,250.20 / 1,000
= 4,250.20 / 1,000
PI (C) = 5,000 + 2,199.75 / 5,000
= 7,199.75 / 5,000= 1.44
Projects B and C are feasible due to their profitability index ratio being greater than 1. The outcomes are consistent with the results for NPV even though there are some instances where they might differ with significant variations of cash flow values.
The most generally accepted method to use in selecting the projects is the profitability index. This is because the profitability index considers the concept of the time value of money and the fact that it is a perfect measure of the profitability of the project (Azizurrofi et al., 2017). This improves project comparability. Besides, this method relies on ratios rather than absolute amounts used by NPV therefore, preventing the over consideration of such projects with higher dollar values.
Azizurrofi, A., Firdaus, R. R., Akbar, W. J., Adisatria, A. R. I. N. G. G. A., Asnidar, A. S. N. I. D. A. R., Iskandar, A. R. I., & Misfaroh, Z. (2017, April). Economic Analysis of Profitability Index and Development Cost Based on Improved Oil Recovery (IOR) Projects in Indonesia. In IOR 2017-19th European Symposium on Improved Oil Recovery (Vol. 2017, No. 1, pp. 1-9). European Association of Geoscientists & Engineers.
Marchioni, A., & Magni, C. A. (2018). Investment decisions and sensitivity analysis: NPV-consistency of rates of return. European Journal of Operational Research, 268(1), 361-372.