Decide Between Two Projects

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En provenance du cours de Indian School of Business

Accounting and Finance for IT professionals

74 notes

Indian School of Business

Accounting and Finance for IT professionals

74 notes

Cours 3 sur 6 dans Specialization Business Technology Management

This course presents an introduction to the basics of financial accounting and finance for IT professionals. The first part of the course will focus on understanding the most important financial statements, namely, the balance sheet, the income statement, and the statement of cash flows. We will then focus on how we can understand the financial health and performance of the company by examining a number of important financial ratios that are derived from the financial statements of the company. The second part of the course will focus on the basics of finance. This includes the concept of time value of money, discounting cash flows, and capital budgeting. The course will also introduce the idea of real options, how they affect a project’s NPV, and their impact of the decision to accept/reject a project. Lectures on concepts will be supplemented with numerical examples.

À partir de la leçon

Capital Budgeting

In this series of videos, we will cover the various aspects related to deciding whether to accept or reject investment in a project. This starts off by discussing the common decision tools, namely, net present value (NPV), internal rate of return (IRR) and payback period (PBP) and how to calculate and interpret them. We will then move on to what free cash flows are and how to estimate them. Finally, we will focus on the flexibilities in projects, how to value them and how they affect the decision to accept or reject projects.

Net Present Value4:55

Internal Rate of Return and Payback Period5:41

Decide Between Two Projects6:31

Drawbacks of Payback Period4:05

Drawbacks of IRR and NPV6:29

Free Cash Flows7:22

Other Relevant Cash Flows4:18

A Capital Budgeting Example7:53

Sensitivity Analysis4:35

Uncertainties in Projects4:10

Resolving Uncertainties7:00

Rencontrer les enseignants

Ramabhadran Thirumalai
Assistant Professor
Indian School of Business

[MUSIC]

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.

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.

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.

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.

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.

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.

[MUSIC]

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