Your company Portfolio Manager is convening a review board in the first calendar quarter to consider three 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.
Project sponsors have provided the following estimated cash flow projections:
Project A Project B Project c
Year Outflow Inflow Netflow Outflow Inflow Netflow Outflow Inflow Netflow
0 $150,000 -$150,000 $150,000 -$150,000 $200,000 $200,000
1 $20,000 $20,000 $130,000 $40,000 $90,000 $150,000 $150,000
2 $30,000 $30,000 $50,000 $50,000 $90,000 $90,000
3 $40,000 $40,000 $60,000 $60,000 $100,000 $100,000
4 $40,000 $40,000 $90,000 $90,000 $110,000 $110,000
5 $50,000 $50,000 $90,000 $90,000 $120,000 $120,000
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).
Based on your analysis, which project would you recommend and why?
Show all calculations supporting your recommendation.
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.