Financial Analysis Case Using Npv
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Upon initial examining of the cash flows for Exhibit 1, some of the eight projects can be ranked and others dismissed. For example, by adding cash flows and deducting the initial investment, we can immediately conclude a possible project ranking of 3,5,8,4,1,7,6,2.
Project
Net Profit(In thousands)
$ 8,000.00
$ 2,200.00
$ 2,150.00
$ 1,561.00
$ 1,310.00
$ 560.00
$ 200.00
$ 165.00
On initial inspection it would seem prudent to select our four best projects based on which of the four will provide us with the highest return. However, this should not be the primary determinant in measuring how effective each of the projects will be in terms of overall profitability.
In my analysis of the anticipated project cash flows I examined multiple methods. Payback Period, Discounted Payback Period, NPV (Net Present Value), IRR (Internal Rate of Return), and EAA (Equivalent Annual Annuity). While each of these methods was given consideration, some provide more accurate results than others. Payback Period and Discounted Payback Period, while easy to calculate, do not take into account all cash flows after the cutoff date. Additionally, these methods give equal weight to all cash flows before the cutoff date. In general, the Discounted Payback Period is considered more reliable than Payback Period alone but should not be used as the sole means of determining profitability.
IRR or Internal Rate of Return is considered by most experts to be a much more reliable means and is used by many firms. Still, IRR does have its drawbacks:
Difficulty determining lending or borrowing in Cash Flows.
Multiple rates of return providing differing discount rates.
Valuing mutually exclusive projects the same.
Inability to Finesse the Term Structure of Interest Rates.
For these reasons and because our Exhibit does have projects that are mutually exclusive (Projects 7 and 8), I would also recommend against using this method.
Because NPV or Net Present Value recognizes the time value of money, it is usually the primary selection criterion used in analysis. NPV is widely recognized as the most reliable means of determining profitability because it takes into account the forecasted cash flows from the projects and the opportunity cost of capital. Because present
values are measured in todays dollars all of them can be added up. However, there are multiple projects in Exhibit 1, each with its own differing duration. In this case, should we have decided to use NPV alone, it would have been a serious mistake.
Instead, Equivalent Annual Annuity would be the most proper method for determining profitability. The EAA (Equivalent Annual Annuity) method calculates the annual payments a project would provide if it were an annuity. When comparing projects of
unequal lives, the one with the