Question

4) The Budwell & Son Oil Company is looking at two drilling proposals. One project lasts for three years, costs $20M to start, pays back quickly, and has an NPV of $15M. The other project also costs about $20M to start, but has an expected life of seven years, takes much longer to pay back, and has an NPV of $17M. Mr. Budwell, the company's founder, favors the shorter project because of the quick investment recovery. His son Billy, however, has taken finance in college and insists that the only way to judge projects is on NPV. He therefore favors the longer project. They've engaged you as their financial advisor to settle the issue. How would you advise them?

Answer 1

Its given that -

project 1 has shorter life with NPV of 15mil and investment of 20 mil

Project 2 has longer life with NPV of 17mil and investment of 20 mil

Thought project 1 is able to quickly able to generate the cash flow but its not considering time value of money into account while computing the payback period.

NPV take care of time value of money using the required rate of return and therefore project with higher NPV is preferred.

NPV method of project evaluation is always better than payback period .

therefore Billy is right here.

2nd project with 17mil NPV should be accepted.