Which project to choose?

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Permalink Reply by Peter Quigley on March 12, 2010 at 3:40am

(a) E; (b) 11m in the hole for a mid range NPV? - a "no brainer" as they say. All the risk is up front. What happens on a default - you are sunk if not insured; (c) The one that makes the most $. NPV before IRR, so B. (Think of it like this: would you rather have a 100% return when you lend me $1 and I return you $2; or a 50% return when you lend me $100 and I give you $150 back. Option 2 has the lower IRR but you are $49 better off.

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Permalink Reply by Naresh Lankala on March 12, 2010 at 10:46am

a) I understand why you chose E, but why not D because it has the highest discount rate? Do I look at the cash outlay today or the discount rate?

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Permalink Reply by Krishnan Mak on March 29, 2010 at 9:27am

Hi,
Normally the project with a high discount rate is said to be of high risk. It is because of this high risk the expected returns are high and hence the discount rate is high. From the given data - the order of riskiness is D, B, E, A and C.
If project A & B are mutually exclusive - then the best choice is Project B which has a higher value addition to the shareholders i.e. $ 13.6 as against $ 11.2 for Project A .. again subject to any limitation on fund availability, and the risk appetite of investor. Project B has a higher NPV ($13.6) though has used a higher discount rate than project A.

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Permalink Reply by Arsen Hayrumyan on March 31, 2010 at 2:29am

Yes, Project D is the riskiest one, because it has highest discount rate (20%). As to question c. I am not sure about Project B to be better than A. Mr. Krishnan Mak did not take into account IRR of project B - 17.1% (NPVB = 0), while for Project A it is 24.2% . We can use profitability index here...PV of inflows / PV of outflows, Project A = 14.8/3.6 = 411% , Project B = 22.5/8.9 = 253%.

The advantage of using profitability index to measure investment opportunities is that it allows you to compare two investment opportunities that require different initial investments. Primarily because profitability index is not sensitive to the amount of the investment.

Here everything depends on amount on hand (projects are not a problem, they are available). If you have $10 to invest, you can invest $3.6 in project A and $5.0 in C. Total NPV (A+C) = $11.2 + $4.2 = $15.4 > $13.6 (Project B)

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