6.

Mutually exclusive projects

A company is considering which of two mutually exclusive projectsit should undertake. The
finance director thinks that the project withthe higher NPV should be chosen, whereas the
managing director thinksthat the one with the higher IRR should be undertaken, especially
asboth projects have the same initial outlay and length of life. Thecompany anticipates a cost of
capital of 10%, and the net after tax cashflows of the projects are as follows:

Required:

(a)Calculate the NPV and IRR of each project.

(6 marks)

(b)Recommend, with reasons, which project you would undertake (if either).

(4 marks)

(c)Briefly explain the inconsistency in ranking of the two projects in view of the remarks of the
directors.

(2 marks)

(d)Discuss the advantages anddisadvantages of the payback and accounting rate of return
methods ofinvestment appraisal. Note: you are not required to perform anycalculations for these
two methods; if you do, you will not score anymarks for it.

(13 marks)
(Total 25 marks)

Answer for Number 6. Mutually exclusive projects

NPV (Y, 10%) = $18,527

(b)Project X, when discounted atthe cost of capital 10%, has the highest NPV. However, Project
Y has ahigher IRR than Project X. When a conflict arises between the NPV andIRR criteria,
select the project with the highest NPV. Therefore ProjectX should be accepted in preference to
Project Y.

(c)Project Y's cash flow occursmainly in year 1, whilst most of X's comes in the years 2 to 4.
This isthe reason for Y's higher IRR, because the IRR calculation assumes thatany monies
reinvested during the life of the project are reinvested atthe project's IRR rather than at the
company's cost of capital (thelatter being the assumption of the NPV calculation).

(d)The payback period is the time taken to recover initial investment.

The accounting rate of return is a percentage measure. It is the ROCE of an investment.

Que 9. Quadrant

Quadrant is a highly geared company that wishes to expand itsoperations. Six possible capital
investments have been identified, butthe company only has access to a total of $620,000. The
projects may notbe postponed until a future period. After the projects end, it isunlikely that
similar investment opportunities will occur.

Expected net cash flows (including residual values) are:

Projects A and E are mutually exclusive. All projects are believedto be of similar risk to the
company's existing capital investments.

Any surplus funds may be invested in the money market to earn areturn of 9% per year. The
money market may be assumed to be anefficient market.

Quadrant's cost of capital is 12% per year.

Required:

(a)Calculate the expected Net Present Value for each project, and rank the projects.

(7 marks)

(b)Assuming the projects aredivisible, calculate the profitability index for each project, and
rankthe projects to determine how the money would be best invested. Explainbriefly why the
rankings differ from that in (a) above.

(7 marks)

(c)Now assume the projects are indivisible. Provide advise on how the funds are best invested.

(5 marks)

(d)Explain how uncertainty and risk could be considered in the investment process.

(6 marks)
(Total: 25 marks)
Aswer 9. Quadrant

(a)NPV calculations

Note: Projects A and D are annuities, so it may be quicker to calculate the NPVs as follows:

Project A NPV = –$246,000 + 3.605 × $70,000 = $6,350

Project D NPV = –$180,000 + 3.037 × $62,000 = $8,294

There is a slight difference to the answer above through rounding.Either answer is acceptable.
Note it will make a slight difference tosome of the answers below.

Ranking of projects:
(b)Profitability index is:

Ranking of projects:

The money should therefore be invested as follows:

The rankings differ from (a) because NPV is an absolute measurewhereas the profitability index
is a relative measure that takes intoaccount the different investment cost of each project.

(c)The objective is to select acombination of investments that will maximise NPV subject to a
totalcapital outlay of $620,000. Projects A and E are mutually exclusive, andproject C has a
negative NPV. The following are potential combinationsof projects:

 Best option

Note: It is not possible to combine four projects within theconstraints outlined above, and
expected NPV cannot be increased bycombining two projects.

Accepting projects A, D and F will maximise NPV

(d)Risk and uncertainty may be considered in several ways. For example:

Adding a risk premium to the discount rate

A premium may be added to the usual discount rate to provide asafety margin. Marginally
profitable projects (perhaps the riskiest) areless likely to have a positive NPV. The premium may
vary from projectto project to reflect the different levels of risk.

Payback period

Estimates of cash flows several years ahead are quite likely to beinaccurate and unreliable. It
may be difficult to control capitalprojects over a long period of time. Risk may be limited by
selectingprojects with short payback periods.

Sensitivity analysis

Sensitivity analysis typically involves posing 'what if' questions.For example, what if demand
fell by 10%, selling price was decreased by5%, etc. Alternatively, we may wish to discover the
maximum possiblechange in one of the parameters before the project is no longer viable.This
maximum possible change is often expressed as a percentage:

This would be calculated for each input individually. The key is to identify the relevant cash
flow.

Probability distribution

A probability distribution of expected cash flows may bedetermined, and hence the expected
NPV (EV) may be found together withrisk analysis e.g. best possible outcome, worst possible
outcome,probability of a negative NPV. A more sophisticated measure of risk isto calculate the
standard deviation. This considers the degree ofdispersion of the different possible NPVs around
the expected NPV. Thegreater the spread of outcomes around the expected NPV, the higher
thepotential risk. The coefficient of variation should be calculated tocompare projects.