Cash Flows (in thousands of USD) Year 0 1 2 3 4 5 6 7 Project 1 -100 10 20 0 0 1
ID: 2774231 • Letter: C
Question
Cash Flows (in thousands of USD)
Year
0
1
2
3
4
5
6
7
Project 1
-100
10
20
0
0
110
0
0
Project 2
-100
0
0
0
40
50
80
10
Project 3
-250
0
15
20
30
40
150
110
Project 4
-500
150
150
-100
50
100
150
200
Project 5
-400
100
100
-100
200
200
-80
130
In the above table, five projects were proposed from different departments of the firm trying to compete for the total $1,000,000 capital budget for next year. The CFO made it clear at the meeting that any project with zero or negative NPV should not be funded. Given it is a pharmaceutical firm, the CFO and the key managers are used to concepts of investing in the long-term projects and/or relatively risky projects, and/or projects with volatile cash flows over time. In addition, most of the members on the committee are cautiously optimistic about the future outlook of the economy. Around the time of the meetings, there were rumors that the Federal Reserve Bank is considering increasing the prime interest rates.
1) We notice that Project 1 will finish in 6 years while others end in 8 years. Is this going to affect your analysis? Under what assumption can we use the replacement chain or the EAA (Equivalent Annual Annuity) to compare projects with unequal lives?
Cash Flows (in thousands of USD)
Year
0
1
2
3
4
5
6
7
Project 1
-100
10
20
0
0
110
0
0
Project 2
-100
0
0
0
40
50
80
10
Project 3
-250
0
15
20
30
40
150
110
Project 4
-500
150
150
-100
50
100
150
200
Project 5
-400
100
100
-100
200
200
-80
130
Explanation / Answer
Yes this is going to affect the analysis because simply using NPV method doesnot give us the true picture of the profitability of the project. There might be cases where NPV of project 1 is lesser than that of other projects however project 1 could be more profitable if it is executed repeatedly or if the effective annual annuity is calculated.
Assumptions required:
1) Projects are mutually exclusive. Any project can be chosen at a time but not more than one.
2) Projects are expected to be replaced indefinitely as they wear out.
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