Question

Year Project A Expected Cash Flows ($) 0 (1,250,000) 1 75,000 2 218,750 3 535,000 4 775,000 5 775,000 Year Project B Expected Cash Flows ($) 0 (1,050,000) 1 650,000 2 500,000 3 226,250 4 137,500 5 62,500 Metrics Payback Period (in years) (A)3.54 (B)1.8 Discounted payback period (in years) (A)4.58 (B)2.72 Net Present Value (NPV) (A)$160,816 (B)$151,742 Internal Rate of Return (A)18.90% (B)23.84% Profitability Index (A)1.13 (B)1.14 Modified Internal Rate of Return (MIRR) (A)17.82% (B)18.15% a). Which of the metrics would you propose and why? b). Which of the projects would you recommend. c) What will be the limitations of the chosen metrics and outline what further analysis you would recommend.

There was no specific discount rate but in the question it was noted that the required rate of return was 15%.

Answer 1

a) I would propose NPV over other metrics because NPV indicates the value added to the firm by undertaking a project, which will be reflected in the stock price over a period of time.

b) As NPV is higher for A, you should recommend Project A.

c) The biggest limitation of NPV is that it is highly sensitive to discount rates. At required return of 15%, NPV for A is higher but it could be a case that for a different required return, NPV of B could be higher.

In order to outcome this bias, we need to further evaluate the specific details about required return for each project depending on their risk.