54.1
1.You are in charge of considering the following
two projects. Your firm can only do one of them and you have to
decide which one to do. The projects have 4-year lives and their
cash flows (in millions) are given in the table.
0 |
1 |
2 |
3 |
4 |
|
Project A |
-5000 |
2500 |
2000 |
500 |
3300 |
Project B |
-4000 |
1000 |
3000 |
2000 |
700 |
The IRR of Project A is 24% and the IRR of Project B is 25%. The NPV of Project A is $1555 million and the NPV of Project B is $1369 million.
a. What are the payback periods of the two projects? [1 pt]
Payback period simply measures the time it takes to earn undiscounted cashflows equal to your initial investment. In this case, it takes 3 years for project A (2500+2000+500 = 5000) and 2 years for project B (1000 + 3000 = 4000).
b. Your underling suggests taking project B because it has the higher Internal Rate of Return. What do you think? Explain your reasoning. [2 pts]
Ahh, young padawan, you have much to learn in the ways of finance. Using IRR to choose between two projects is succumbing to the dark side. Once you give yourself to the dark side, forever will it rule your actions. The most obvious problem here is that the two projects have different initial investments (5000 vs. 4000). Thus, the two projects are not comparable on rates of return because the bases of the return are different (when you can only do one project, it's not better to earn 25% on 4000 instead of 24% on 5000). Additionally, you know that the NPV of project A is greater than the NPV of project B. This means that project A adds more value than does project B, so since our goal is to add actual value that can be spent on things, we choose the project that adds the most value.