Connor Corporation is considering two projects (see below). For your analysis, assume these projects are mutually exclusive with a required rate of return of 10%.
Project 1 Project 2
Initial investment $(465,000) $(700,000)
Cash inflow Year 1 $510,000 $850,000
Compute the following for each project:
• NPV (net present value)
• PI (profitability index)
• IRR (internal rate of return)
Based on your analysis, answer the following questions :
• Which is the best choice? Why?
• Which project should be selected and why? If the projects had the same IRR amounts but different NPV totals, then how would you know which project to select? Explain.
• What would happen if both projects had negative NPV totals? Which project would you choose? What do negative NPVs indicate? Explain.
• Should we also use the payback method to assist us in project selection? Why or why not? Explain.
Analysis of Projects for Connor Corporation
To determine the best choice between Project 1 and Project 2, we will calculate the Net Present Value (NPV), Profitability Index (PI), and Internal Rate of Return (IRR) for each project. We will assume a required rate of return of 10%.
Project 1:
Initial investment: $(465,000)
Cash inflow Year 1: $510,000
Net Present Value (NPV): NPV is calculated by discounting the cash inflows and outflows of a project to their present value and subtracting the initial investment.
NPV = Cash inflow Year 1 / (1 + Required rate of return) - Initial investment NPV = $510,000 / (1 + 0.10) - $465,000 NPV = $464,545.45 - $465,000 NPV = -$454.55
Profitability Index (PI): PI is calculated by dividing the present value of cash inflows by the initial investment.
PI = Present value of cash inflows / Initial investment PI = $510,000 / $465,000 PI ≈ 1.0968 or 109.68%
Internal Rate of Return (IRR): IRR is the discount rate at which the NPV of a project becomes zero. In this case, since there is only one cash inflow, the IRR can be calculated directly.
IRR = Cash inflow Year 1 / Initial investment IRR = $510,000 / $465,000 IRR ≈ 1.0968 or 109.68%
Project 2:
Initial investment: $(700,000)
Cash inflow Year 1: $850,000
Net Present Value (NPV):
NPV = Cash inflow Year 1 / (1 + Required rate of return) - Initial investment NPV = $850,000 / (1 + 0.10) - $700,000 NPV = $772,727.27 - $700,000 NPV = $72,727.27
Profitability Index (PI):
PI = Present value of cash inflows / Initial investment PI = $850,000 / $700,000 PI ≈ 1.2143 or 121.43%
Internal Rate of Return (IRR):
IRR = Cash inflow Year 1 / Initial investment IRR = $850,000 / $700,000 IRR ≈ 1.2143 or 121.43%
Analysis and Answers:
Based on the calculations:
Project 1 has an NPV of -$454.55, a PI of 109.68%, and an IRR of 109.68%.
Project 2 has an NPV of $72,727.27, a PI of 121.43%, and an IRR of 121.43%.
The best choice between the two projects depends on the decision criteria and objectives of Connor Corporation:
If the primary focus is maximizing NPV, then Project 2 would be the best choice as it has a positive NPV of $72,727.27 compared to Project 1’s negative NPV.
If the primary focus is maximizing the profitability index, then Project 2 would be the best choice as it has a higher PI of 121.43% compared to Project 1’s PI of 109.68%.
If the primary focus is maximizing IRR, then both projects are equal choices as they have the same IRR of 109.68%. In this case, other factors such as project size or risk may need to be considered.
If the projects had the same IRR amounts but different NPV totals, selecting the project with the higher NPV would still be the preferred choice. NPV takes into account the time value of money and provides a more accurate measure of project profitability.
If both projects had negative NPV totals, it would indicate that neither project generates enough cash flows to cover the initial investment and provide a positive return. In such a scenario, Connor Corporation should carefully evaluate other qualitative factors such as strategic importance or potential long-term benefits before making a decision.
The payback method measures how long it takes for a project to recover its initial investment. While payback period analysis can provide a quick assessment of liquidity and risk, it does not consider the time value of money or provide a comprehensive measure of project profitability. Therefore, it is generally not sufficient as the sole method for project selection. Instead, using methods like NPV, PI, and IRR provide a more thorough evaluation and help in making informed decisions regarding project selection.
In conclusion, based on the analysis provided:
If maximizing NPV or profitability index is the primary objective, Project 2 should be selected due to its positive NPV and higher profitability index.
If maximizing IRR is the primary objective and both projects have the same IRR but different NPVs, selecting the project with the higher NPV would still be preferred.
Negative NPVs indicate that both projects fail to generate positive returns on their initial investments. In such cases, qualitative factors should be considered before making a decision.
Payback method alone may not provide sufficient information for project selection as it does not consider the time value of money or provide a comprehensive measure of profitability.