Howdy Ltd relies on the payback method of project evaluation, requiring that investments repay capital within three years. The board are currently considering the four projects listed below: (ignore tax)
Project A B C D
$ $ $ $
Sales 40,000 75,000 60,000 60,000
Direct costs 16,000 27,000 15,000 18,000
Depreciation 8,000 40,000 30,000 35,000
Interest 12,000 16,000 9,000 7,000
Initial investment 120,000 160,000 90,000 70,000
Project life (years) 10 10 18 15
The engineering department has requested the board to evaluate these opportunities by means of a discounted cash flow technique. The finance department personnel have been unwilling to use a discounted cash flow technique because of difficulty in establishing an appropriate discount rate. They therefore propose to calculate each project's internal rate of return and let the board determine appropriate hurdle rates. Required:
(b) Calculate each project's internal rate of return (IRR) and using a hurdle rate of 15%, state which of the opportunities is acceptable by this criterion.
(c) Discuss the possible reasons why the above two project appraisal methods do not give answers which are consistent with each other, for the accept/reject decision. Which should the board employ? Why?
(d) Discuss some of the elements which should be considered when determining the appropriate hurdle rate for an individual project.