Consider the following statement by a project analyst: \"I analyzed my project u
ID: 2793122 • Letter: C
Question
Consider the following statement by a project analyst: "I analyzed my project using scenarios for the base case, best case, and worst case. I computed break-evens and degrees of operating leverage. I did sensitivity analysis and simulation analysis. I computed NPV, IRR, payback, AAR, and PI. In the end, I have over a hundred different estimates and am more confused than ever. I would have been better off just sticking with my first estimate and going by my gut reaction." Critique this statement. In answering this question please make sure you define each of the concepts stated in this statement.
Explanation / Answer
Net Present Value (NPV):
In the net present value method where in the future cashflows inflows/outflows are discounted at a rate and compared whether the NPV is +ve,-ve or Zero.
Ideally NPV depends on the following.
a. Cash Inflows
b. Rate of Discounted Cash flows.
c. If the said cash flow is generating income to the firm
Generally NPV has to be +ve to select a project.
Internal Rate of Return (IRR):
IRR is defined at the discount rate at which NPV becomes "Zero". In other terms IRR indicates the retun rate at which the project shall break even.
IRR depends on.
a. Magnitude of Investment
b. Timing of cash flows
In Simple terms, NPV clearly indicates the amount of cash inflow to the firm from the project. While IRR tells about rate at which earnigns come.
IRR has a pitfall - It assumes that the earnings are ploughed back in the same project and assumes equal timing / intervals. To overcome the same firms use Modified IRR (when cash flow from a project is used to fund other activites of firm) or XIRR (timing change).
Hence a firm shall be more interested in maximizing the cashflows which it can earn over a period of time. Also the discount rate is well known basis firms historic debt to equity levels.
ARR - Accounting Rate of Return:
In this method, the accounting profits / book profits are used for finding out the metirc of return and not the actual cashflows. Also it does not consider time value of money into account.
In other terms ARR is also called as Retrun on Capital Employed (ROCE) - i.e PBIT / Total Capital Employed.
You can accept the project if the ARR is greater than the traget rate (as set by top mgmt).
It would be prudent to calcuate ARR for each year of useful life of the project and compare the same with Target rate. If ARR is declining then it is an indication that the project may not be considered.
Profitability Index:
PI is defined as present value of future cashflows upon Initial Investment. Any value equal to one is desirable and value less than one indicates that project is not attractive. As the name indicates it is the index and is used especailly while comapring projects when firm has limited capital and two or more baskets to invest for maximizing shareholder's wealth.
PayBack:
Payback is a very simple metric. It is calcualted by dividing investment (cash outflows) with the cash inflows. It gives the time period required for a firm the recover its capital.
It doesn't consider time value of money while NPV IRR and PI considers the same.
Reasoning:
The reasoning is done based on the inputs provided in problem statement. Since you have done an extensive study on sensitivity cases,you would have plotted the NPV,IRR,PI, Payback, ARR.
Since NPV, IRR, PI considers time value of money it would you can consider the results of 3 for filtering your metrics.
a. Since you are considering only 1 project PI in all the cases base, worst and best case sceario shall be greater than 1.
b. NPV shall be positive or Zero shall be while benchmarking agaisnt the worst case scenario.This indicates that your project shall generate +ve cash flows.
c. While using IRR the rate shall always be greater than the hurdle rate (Rate set by top mgmt) for approval of a project in best and base case scenrios. Note that you can try calcualting Equity IRR for the project and if the equity IRR is greater than the historical ROE of your firm you can consider the project.