Your company Portfolio Manager is convening a review board in the first calendar quarter to consider three mutually exclusive projects. You have been asked to provide recommendations with respect to the capital budgeting aspects of these projects. Your recommendations will be considered by the review board along with other non-financial aspects of the projects. Initial (year 0) funding will be provided in the current year for the single project selected. Note: The review board may select a project for strategic reasons even if the financial aspects are not ideal.
Project sponsors have provided the following estimated cash flow projections:
The company has not yet decided how the selected project will be financed. The cost of capital or hurdle rate will vary depending upon how the company decides to finance the project. You decide to compare projects in three areas: (1) payback period (not considering the cost of capital); NPV sensitivity (see note 1 below); and (3) Internal Rate of Return (IRR). Conduct each analysis and interpret the results.
You must make as complete a recommendation as possible so that the board understands the financial implications of whatever decision they make. Based on your analysis, what would you recommend to the review board and why? Your recommendation must be based on the combination of all three factors (payback period, IRR, and NPV sensitivity).
Show all calculations supporting your recommendation. Calculate NPV to the nearest dollar, IRR to three decimal places, and payback period to one decimal place.
Note 1: Project NPV varies inversely with the cost of funds to perform the project (expressed as the hurdle rate or k in the NPV discount factor formula). Some project NPVs are more sensitive to changes in k than others. See the NPV Profile discussion in Gallagher, Chapter 10, pages 278-279 (Reserved Readings) for information on determining NPV sensitivity.