© 2000 John Petroff
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© 2000 John Petroff |
1)- Calculating NPV, IRR and PI
Table T-10.5 below shows the values of the statistics needed for choosing the projects: BETA, discount rate, NPV, IRR and PI. To start the analysis, in this table all the projects are assigned the same discount rate which is the average cost of capital of Zee Company.
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| . | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 |
| . | Assembly | Intranet | Truck3 | Truck2 | Truck3 | Close w/h | Expand | New prod 1 | New prod 2 |
| Beta |
1 |
1 |
1 |
1 |
1 |
1 |
1 |
1 |
1 |
| Discount rate |
0.1 |
0.1 |
0.1 |
0.1 |
0.1 |
0.1 |
0.1 |
0.1 |
0.1 |
| IRR |
10% |
13% |
15% |
15% |
12% |
10% |
14% |
16% |
14% |
| NPV |
($34.19) |
$22.19 |
$5.94 |
$3.74 |
$4.50 |
($0.18) |
$83.63 |
$139.47 |
$412.13 |
| PI |
$0.97 |
$1.14 |
$1.16 |
$1.14 |
$1.08 |
$0.99 |
$1.18 |
$1.31 |
$1.50 |
On the basis of Table T-10.5, all the projects deserve to be selected except the conveyor belt and the closing of the remote warehouse. These two projects must be rejected on the basis of all three criteria NPV, IRR and PI. One may note that several conflicts are present. For instance between projects 7 and 8: one has a higher NPV and the other a higher IRR. The most profitable project is the new market introduction, and the least the conveyor belt according to all methods, NPV, IRR and PI.
The omission of risk factors is a major deficiency of the previous approach. The above statistics are in fact presented to contrast with the values presented in next table where risk is incorporated. The risk is built into the calculation by adjusting the discount rate in the same manner as described in Chapter 2 (i.e. k= RFR + BETA*(WACC-RFR)). Values of beta assigned to each project reflect whether the project adds to sales and production instability, or reduces it. Thus, for instance, the new conveyor belt reduces the potential for missed sales, and thus the beta assigned is lower than Zee Company overall beta of 1. Choosing truck either 2 or 3 is risk neutral because the company already uses this equipment and beta is just 1, the same as the overall company. This is not true for truck 1 which is assigned a higher beta value than company average. Sales expansion has a beta that is just a fraction above one. New market penetration is especially risky as described above, and a high beta value is assigned to both projects new product 1 and new product 2. The recalculated statistics are presented in Table T-10.6 below.
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| . | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 |
| . | Assembly | Intranet | Truck1 | Truck2 | Truck3 | Close w/h | Expand sales | New prod 1 | New prod 2 |
| Beta |
0.8 |
0.9 |
1.5 |
1 |
1 |
0.5 |
1.1 |
1.9 |
2.5 |
| Discount rate |
0.092 |
0.096 |
0.12 |
0.1 |
0.1 |
0.08 |
0.104 |
0.136 |
0.16 |
| IRR |
10% |
13% |
15% |
15% |
12% |
10% |
14% |
16% |
14% |
| NPV |
$67.09 |
$25.98 |
$3.32 |
$3.74 |
$4.50 |
$1.41 |
$73.56 |
$47.76 |
($133.77) |
| PI |
$1.05 |
$1.16 |
$1.09 |
$1.14 |
$1.08 |
$1.04 |
$1.16 |
$1.11 |
$0.83 |
Based on Table T-10.6, the selection of projects changes radically. The new market introduction of product 2 becomes undesirable (whereas it was the most profitable project in the previous table) and the conveyor belt turns out to have one of the highest NPV (whereas it had a negative NPV in the previous table). Closing of the remote warehouse also switches to become a profitable choice. A number of conflicts and issues have now emerged and are apparent in the choice of truck (truck 1 has a higher IRR and truck 3 has a higher NPV) and the choice of marketing strategy (sales expansion has a higher NPV but new product 1 has a higher IRR). These conflicts and issues will be analyzed in the following paragraphs. But, next, let us review the characteristics of each type of project.
See review questions Q-10E1.1 and Q-10E1.2.
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