INVESTMENT DECISIONS AND STRATEGIES
5.8 RANKING MUTUALLY EXCLUSIVE PROJECTS
Table 5.5
Calculation of the ARR on total assets
Year
1 2 3 4 Average ARR
Project Lara
Cash flow (£) 16,000 16,000 16,000 12,000 – Depreciation* (£) (10,000) (10,000) (10,000) (10,000) –
Accounting 6,000 6,000 6,000 2,000 5,000
profit (£) Carling
Cash flow (£) 17,000 17,000 17,000 17,000 – Depreciation* (£) (12,500) (12,500) (12,500) (12,500) –
Accounting 4,500 4,500 4,500 4,500 4,500
profit (£)
*Straight-line depreciation is used in each case.
9%
4,500>50,000 1212% 5,000>40,000
Self-assessment activity 5.3
List four capital budgeting methods for evaluating project proposals. Identify the main strengths and drawbacks of each.
(Answer in Appendix A at the back of the book)
Suppose the manufacturers of the Lara also make the Bruno – a larger, more powerful, but more erratic model – offering a further 50 per cent in cost savings each year, but costing a further 50 per cent to purchase. The NPV will be 50 per cent greater than the Lara, but the other measures of performance – based on ratios or percentages – will be the same, as shown in Table 5.6.
Table 5.6
Comparison of various appraisal methods
Lara Bruno Carling
Net present value (£) 4,252 6,378 (467)
Internal rate of return (%) 19.3 19.3 13.5
Profitability index 1.1 1.1 0.99
Payback period (years) 2.5 2.5 2.9
Accounting rate of return (%) 25.0 25.0 18.0
In ranking mutually exclusive capital projects, we can reject the Carling for hav- ing a negative NPV and performance indicators that are consistently inferior to the alternatives. While the Bruno and Lara are, pound-for-pound, identical, the Bruno cre- ates £2,126 additional wealth and is preferred.
Under the conditions typically found in business, no single method is ideal, which is why three or four different measures are often calculated. The ready availability of spreadsheet packages with graphics facilities makes this a straightforward and inex- pensive procedure. Investment appraisal techniques are tools to assist managers in assessing the worth of a given project.
■ NPV or IRR?
In many cases, the choice of DCF method has no effect on the investment advice, and it is simply a matter of personal preference. In certain circumstances, however, the choice does matter. We shall consider three such situations:
1 Mutually exclusive projects.
2 Variable discount rates.
3 Unconventional cash flows.
■ Mutually exclusive projects
The decision to accept or reject a project cannot always be separated from other invest- ment projects. For example, a company may have a spare plot of land that could be used to build a warehouse or a sports centre. In such cases, the problem is to evaluate mutually exclusive alternatives.
The earlier worked examples comparing the Lara, Carling and Bruno proposals are mutually exclusive. Recall that, while the Lara and Bruno offered the same IRR, the lat- ter offered a much higher NPV because it was on a larger scale. The weakness of IRR is that it ignores the scale of the project. It implies that firms would prefer to make a 60 per cent IRR on an investment of £1,000 than a 30 per cent return on a £1 million project. Clearly, project scale should be taken into consideration, which is why we rec- ommend the NPV method when assessing mutually exclusive projects of different size or duration.
■ Variable discount rates
It is common to discount cash flows at a constant rate of return throughout a project’s life.
But this may not always be appropriate. The required rate of return is linked to underly- ing interest rates and cash flow uncertainties, both of which can change over time.
This presents little difficulty in the case of NPV: different discount rates can be set for each period. The IRR method, however, is compared against a single required rate of return and cannot handle variable rates.
■ Unconventional cash flows
There are three basic cash flow profiles:
Type Cash flow pattern Example
Conventional Outlay followed by inflows Capital project Reverse Inflow followed by outflow Loan
Unconventional More than one change of sign Two-stage development project For a reverse cash flow pattern, such as a loan where cash is received and interest paid in subsequent periods, the IRR can be usefully applied. But in interpreting the result, remember that the lower the rate of return the better, so the decision rule is to accept the loan proposal if the IRR is below the required rate of return.
Unconventional cash flow patterns create particular difficulty for the IRR approach.
Consider the following project cash flows and NPV calculation at 10 per cent required rate of return.
£ PVIF at 10% PV (£ 000)
Initial outlay 0 1.00
Year 1 0.909 327
2 0.826
3 0.751 130
NPV 0
With an NPV of zero, the IRR is, by definition, 10 per cent. But at certain other rates, such as 20 per cent and 30 per cent, the NPV is still zero!
Multiple solutions may occur where there are multiple changes of sign. In our example there are three changes in sign – from negative cash flow at the start to posi- tive in Year 1, negative in Year 2 and positive in Year 3. While a conventional project has only one IRR, unconventional projects may have as many IRRs as there are changes in the cash flow sign.
173,000 357 432,000
360,000 100 100,000
12 12 12
To summarise, the use of NPV and IRR is a matter of personal preference in most instances. But where the evaluation is for mutually exclusive projects, where the dis- count rate is not constant throughout the project’s life, or where an unconventional cash flow pattern is suspected, we recommend use of the net present value approach.
To underline the superiority of NPV we need to examine the respective reinvestment assumptions of the two methods.
The NPV method assumes that all cash flows can be reinvested at the firm’s cost of capital. This is entirely sensible, since the discount rate is an opportunity cost of capi- tal that should reflect the alternative use of funds. The IRR method assumes that a pro- ject’s annual cash flows can be reinvested at the project’s internal rate of return. Thus, a project offering a 30 per cent IRR, given a 12 per cent cost of capital, assumes that interim cash flows are compounded forward at the project’s rate of return (30 per cent) rather than at the cost of capital (12 per cent). In effect, therefore, the IRR method
Self-assessment activity 5.4
Why do problems arise in evaluating mutually exclusive projects? What approach would you recommend in such circumstances?
(Answer in Appendix A at the back of the book)
includes a bonus of the assumed benefits accruing from the reinvestment of interim cash flows at rates of interest in excess of the cost of capital. This is a serious error for projects with IRRs well above the cost of capital.
Consider the mutually exclusive investment proposals given in Table 5.7. X and Y each cost £18,896. Project rankings reveal that X has the higher internal rate of return but the lower net present value. Figure 5.2 shows how this apparent anomaly occurs.
(Strictly speaking, the graphs should be curvilinear.)
While Project Y has the higher NPV when discounted at 10 per cent, it has the lower IRR, the two projects intersecting in the graph at around 17 per cent. Wherever there is a sizeable difference between the project IRR and the discount rate, this problem becomes a distinct possibility.
0 5 10 15 20 25
Rate of interest (%) 20,000
15,000 10,000 5,000
Project Y
Project X 8,290
6,463
NPV (£)
Intersection point (17%)
Figure 5.2
NPV and IRR compared Table 5.7
Comparison of mutually exclusive projects
Cash flows (£)
Undiscounted NPV Proposal Year 0 Year 1 Year 2 Year 3 Year 4 cash flow IRR at 10%
X 8,000 8,000 8,000 8,000 13,104 25% 6,463
Y 18,89618,896 0 4,000 8,000 26,164 19,268 22% 8,290
Harry Potter and the global sales hopes of Coca-Cola
When the long-awaited Harry Pottermovie opened one of the biggest stars was not even seen on film. As millions enjoy Harry Potter and the Philosopher’s Stone, Coca-Cola is assuming the role of exclusive marketing partner.
Never has so much been poured into one movie by one company. Since lengthy negotiations with Warner Bros Pictures for exclusivity last year, the beverage group has sunk $150 million into a global marketing programmes usually preserved for world sporting events such as the Olympics.
In many ways,Harry Potteris able to do what Coca-Cola has been attempting for many years – to reach out to a younger audience while not alienating adults. That is crucial as Coca-Cola rein- vents itself as an all-beverage company, offering from fun juice drinks to gourmet coffees. But Harry
Potteralso serves another purpose: instantly elevat- ing the Coke brand by its sheer popularity world- wide, something its own advertising campaigns have failed to do. Such a powerful platform seems to justify spending nearly 10 per cent of the group’s global marketing budget on Harry Potter.
The biggest critics Coke has to worry about are its shareholders. Its share price has been rela- tively flat since the announcement of the Harry Pottercampaign. ‘Investors are simply looking for Coke to meet volume goals. That would be enough,’ says Ms Levy, a spokesperson for the firm. ‘If this can help re-establish the brand in the hearts of consumers, then putting 10 per cent of the budget into Harry Potterwon’t be a bad investment.’
Source:Based on Financial Times, November 15 2001.