Learning Outcomes
- Analyze a possible replacement projects to determine if it should be implemented
Let’s assume you, as a manager are presented with two options for projects, and you need to decide which one to implement if any. You have been tasked with analyzing them to determine which may be a good fit for your company, and which one will bring the greatest financial impact to company profits.
This task can seem daunting at first, especially if the options are diverse. Once we have screened all potential projects to make sure they meet the company’s minimum requirements to be considered, we can then rank them by preference before deciding. This process is used when there are limited funds, so all potential options cannot be implemented, or when only one project or piece of equipment would be needed. It may also be used to determine which project to implement first. So even if funds exist to implement more than one, ranking them in order of profitability is important in making capital budgeting decision.
So if funds are limited and only one option can be chosen, using either the internal rate of return (IRR) method or the net present value (NPV) method will yield the best results. Actually, do them both! If they conflict, the NPV method will probably be more reliable.
Using the IRR method, if one project has an IRR of 18% and a second project only has an IRR of 12%, then choosing the higher internal rate of return makes the most sense, right? When using the NPV method we need to adjust for differences in the initial investment of the project to be comparing apples to apples. We need to figure out what the project’s profitability index is, based on the initial investment amounts. Let’s look at an example:
| Hupana Running Company — Which Choice?? | ||
| Project | ||
| Stitcher | Sole Gluer | |
| Initial investment required | $25,000 | $15,000 |
| Present value of cash inflows | $20,000 | $10,000 |
| Net present value | $5,000 | $5,000 |
So back to Hupana again. They have limited funds and can choose to either purchase a stitcher or a sole gluer this year, but not both. Both pieces of equipment have the same net present value, but what is the project profitability for each choice?
Project profitability index = net present value of the project/initial investment required
| Hupana Running Company | ||
| Project | ||
| Stitcher | Sole Gluer | |
| Net present value | 5000 | 5000 |
| Initial investment required | 25000 | 15000 |
| Project profitability index | 20.00% | 33.33% |
So which one would we pick? The one with the higher profitability index, right? So, the sole gluer it is! Maybe Hupana can revisit the stitcher when they have additional funds!
Practice Questions
