Can i get a feedback for this particular post below. thank you 1. I would prefer
ID: 2820334 • Letter: C
Question
Can i get a feedback for this particular post below. thank you
1. I would prefer to use he NPV method for evaluating an investment, because I can easily enter either the WACC or a hurdle rate for choosing projects, like 15% for instance. This would likely be higher than the WACC, but it is a good way of evaluating a project. In fact if a project is deemed to be risky, you could easily enter another rate into the function to see if it passes. Another benefit to the NPV analysis is that you actually get to see in dollar terms the value that is added to the firm from the project, and the surplus that the project will produce. Finally, the NPV can handle variations in the positive and negative cash flows of a project and different discount rates, whereas the IRR cannot. The IRR is more focused on the break even point for a project, and is an additional helpful piece of information for understanding, but I would rely more on NPV for the decision-making.
2. This is a huge issue for doing capital budgeting. When asking questions from different departments it is common to receive a bias, especially if the project is going to directly affect that person or that department. For instance, if the project is a big capital piece of equipment in order to give the engineering department some relief or some added comfort in doing their daily jobs, you could receive some exaggerated information. If you asked them how much time they spend now completing a task, and how much time they would spend if we had such-and-such equipment, they could overstate how much time is wasted now, and overstate the time-savings that would occur from having the equipment. If you went to crunch the numbers, it could clearly look like a good investment because of this bias towards wanting the firm to take on a project. In finance, one of the best tool that you can use is a sensitivity analysis for this. In other words this would be a what-if the hours I was quoted are double what they actually are, or half of what they actually are? How would that affect the project outlook? Multiple drivers can be examined to deal with these biases.
4. For my CEO, I would likely do what I just discussed as being helpful for getting around people's biases, because in a way the CEO seems to have a bias as well for a certain project. In providing the justification I would give her some different scenarios for the project since it is only marginally acceptable. I would show her that if X, Y, or Z happens, which could be quite possible, this project goes from being marginally acceptable to a bad idea. I would hope the CEO is reasonable, and waits for a better opportunity if we are going to be using our resources towards something.
5. I should always be using the weighted average cost of capital when evaluating investments and projects. Especially in this situation where we are considering an expansion project. It does not matter that this year we are only financing using debt for a couple of reasons. First being that even though this year we are using debt, we still owe our preferred stock owners and common stock owners a return on their money, and we shouldn't think they require the same return that the debt-owners require. Second reason being that since this is an expansion project, it will likely be lasting for a number of years, could be 20. Just because this year we are using debt doesn't mean our company won't go back to the weighted average capital structure we have had.
Explanation / Answer
1.
I would prefer to use the NPV method because:
1) It gives me in dollar terms the value added to the firm from the project and hence is consistent with shareholder wealth maximization. IRR gives value in percentage terms and hence is biased towards initial investment size. NPV is not biased by project size.
2) Considers time value of money
3) Handles irregular or non-uniform cash flows: NPV can handle variations in the positive and negative cash flows of a project and different discount rates. IRR many a times is not bale to give a value and sometimes give multiple IRRs so how do we decide which one to take. NPV always gives a single value.
4) NPV assumes reinvestment at hurdle rate or opportunity cost or WACC which is reasonable assumption but IRR assumes reinvestment at IRR which is unreasonable.
5) In case of mutually exclusive projects, NPV and IRR gives conflicting rankings and it is advisable to use NPV
6) NPV allows us to compute NPV at several rates thus giving a picture of the range of cost of capital where the project will be favorable. If a project is deemed to be risky, you could easily enter another rate into the function to see if it passes
2. Perfect
4. Perfect
5.
We will be using WACC in this case because of:
Firstly, the hurdle rate is not dependent on the choice of financing but rather on the riskiness of the project. Depending on the riskiness of the project, we will choose our hurdle rate. But if the project is of the same risk as the firm or average risk, then we are fine with using WACC.
Secondly, Since this is an expansion project it is likely to last much longer than 1 year. Even though this year we are using debt, we still owe our preferred stock owners and common stock owners a return on their money, and we shouldn't think they require the same return that the debt-owners require. Just because this year we are using debt doesn't mean our company won't go back to the weighted average capital structure we have had. Hence, the target capital structure intended for this project should be our key concern.