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In the last few videos, we have seen some of the common tools that managers
use to decide whether to accept or reject projects.
These include the NPV, IRR and the Payback Period.
We have evaluated the accept or reject decision on a single project.
What happens if the manager is looking at alternate proposals and
can accept only one of them?
How do we use NPV, IRR and Payback Period to make this decision?
This is what we will cover in this video.
Let's look at an example.
The CEO of an FMCG firm is considering
Investing in a sophisticated analytics platform that'll
help its Product Development group create superior customer value propositions.
However, its Operations group suggests that
upgrading its supply chain is a better investment.
Given a constrained budget, how does the CEO decide between these two alternative.
We have some additional information on the two projects.
The Business Intelligence Platform will yield incremental profits of $1.56
million and $1.93 million respectively, in the two years following implementation.
Thereafter profits will settle at $1.96 million.
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Maintenance costs for this period are estimated at $180,000 a year.
The platform involves upfront hardware costs of $306,000,
software costs of $612,000 and training costs of $116.000.
On the other hand supply chain reengineering will
yield incremental profits of $2.5 million for
five years following the implementation of the technology.
Upfront implementation costs,
including those on training and consulting, are $1.6 million a year.
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Annual license and maintenance costs are $250,000.
Assume that the discount rate is 15% for
both investments, and that both projects will last for five years.
Let's calculate the NPV, IRR and the Payback Period of the two projects.
For the Business Intelligence Platform, the incremental revenue in the first year
is $1.56 million, in the second year it is $1.93 million, and
in each of years three to five it is $1.96 million.
The annual operating costs are $180,000,
which when subtracted from profits, yields cash flows of $1.38 million and
$1.75 million in years one and two respectively.
And cash flows of $1.78 million in each of the remaining years.
In addition the company needs to invest a total of $306,000 plus $612,000,
plus $116,000, which adds up to $1.034 million.
We can use the MPV function in Excel to calculate the present value of
these cash flows.
The MPV function takes the discount rate as its first input, and
then all the annual cash flows.
The first cash flow must be the year one cash flow and not the year zero cash flow.
Once we get the NPV of all future cash flows,
we can subtract out the year zero cash flows to get that NPV of the project.
The NPV function gives a value of $5.596 million.
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Subtracting the year zero cash flow of $1.034 million,
the Business Intelligence Platform has an NPV $4.562 million.
Using the IRR function in Excel with all the projects cash flows,
gives the project IRR of 147%.
Since the project requires an initial investment of $1.034 million,
and the first year's cash flows are $1.38 million,
it's Payback Period is less than one year.
Specifically, $1.38 million is generated in the entire year.
In what fraction of the year does the company recover $1.034 million?
We get the Payback Period by dividing $1.034 million by $1.38 million,
which gives us 0.75 years or nine months.
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Next, let's calculate the NPV, IRR, and
Payback Period of the supply chain reengineering or project.
It has annual revenues of $2.5 million for five years.
Its annual cost are $250,000.
Subtracting the cost from the revenues,
yields annual cash flows of $2.25 millions in the five years.
Using the NPV function on these five cash flows, yields a value of $7.542 million.
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Subtracting the year zero cost of $1.6 million,
use an NPV $5.942 million for the supply chain reengineering project.
Its IRR comes to 139%, and its Payback Period is $1.6 divided by $2.25.
Which is 0.71 years or approximately eight and a half months.
Next to the decision part.
Both projects have positive NPVs
as well as IRRs far greater than the hurdle rate of 15%.
The Payback Periods are also both less than one year.
In fact, they're almost identical.
So which project should the CEO choose?
The supply chain reengineering option has the higher NPV of $5.942 million,
when compared to the $4.562 million for the Business Intelligence Platform.
This says that supply chain reengineering adds more shareholder wealth
than the Business Intelligence Platform.
And hence the CEO should choose the supply chain reengineering project.
However the Business Intelligence Platform has a higher IRR of 147%,
which says that the CEO should select Business Intelligence Platform.
So NPV and IRR give us contradictory results.
Here we should go with what NPV tells us, as it tells us which project
adds more shareholder wealth at the given discount rate of 15%.
See the figure, at discount rates of less than around 125%,
the supply chain reengineering has the higher NPV.
But at discount rates above 125%,
the Business Intelligence Platform has the higher NPV.
But given that the discount rate is 15%,
supply chain reengineering has the higher NPV.
And hence the CEO should select it over the Business Intelligence Platform option.
Also, IRR is not necessarily appropriate when trying to compare two projects,
as the scale of the projects and/or the cash flow patterns may differ.
For example, doubling all cash flows of both projects
will not change the IRR of the two projects.
Whereas, it'll double the NPV of both projects.
For these reasons,
it is better to use NPV when selecting one project from among many.
While we have seen examples where we have used NPV,
IRR and Payback Period to accept or reject projects,
these methods have some drawbacks which we will discuss the next time.
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Ramabhadran ThirumalaiAssistant Professor
