Question

Suppose your boss has asked you to analyze two mutually exclusive projects—project A and project B. Both projects require the same investment amount, and the sum of cash inflows of Project A is larger than the sum of cash inflows of project B. A coworker told you that you don’t need to do an NPV analysis of the projects because you already know that project A will have a larger NPV than project B. Do you agree with your coworker’s statement?

Answer 1

You coworker is wrong.

Step-by-step explanation:

Sometimes its easier to explain with an example:

Project A Project B

Cash flow 1 50,000 100,000

Cash flow 2 50,000 100,000

Cash flow 3 100,000 100,000

Cash flow 4 100,000 25,000

Cash flow 5 100,000 25,000

total 400,000 350,000

discount rate 15% 15%

NPV 253,930 255,046

Project A's total cash flows are 14% higher than project B's, but the NPV of project B is higher, so project B should be chosen.

The main premise of finance is the value of money in time, and $1 today is worth more than $1 tomorrow. That is why the NPV is the parameter for choosing between mutually exclusive projects.

Answer 2

No.

Step-by-step explanation:

Net present value (NPV) is a capital budgeting technique that is used to evaluate capital expenditures. It takes in-to consideration the time value of money and give a result in an absolute value. The main advantage of NPV is that it evaluates a project in a same way as any shareholder will do, that is, it gives you a value by which the wealth of shareholder will be maximized. For example, if the NPV is $10,000, it means that if capital is invested, the shareholders' wealth will be increased by $10,000. Projects with positive NPV should be selected. However, when mutually exclusive projects are under consideration, then go for a project with greater NPV.

I will not agree with my coworker's statement because investment decisions based on cash inflows has many drawbacks:

- The initial invested capital is ignored.

- We haven't consider the time value of money. What if the Pay-back period of Project B is far less than that of Project A ? Receiving $1 one year later is far better than receiving the same amount after ten years.

- Investors do not evaluate projects based on their cash in-flows. It does not provide them with the value they are concerned with. As discussed above, shareholders are only concerned with their wealth and the NPV technique calculate that value by which their wealth will increase.

So, it is recommended here to conduct NPV analysis for better investment decision.