0:00

[MUSIC]

Â In the last few videos, we have seen some of the common tools that managers

Â use to decide whether to accept or reject projects.

Â These include the NPV, IRR and the Payback Period.

Â We have evaluated the accept or reject decision on a single project.

Â What happens if the manager is looking at alternate proposals and

Â can accept only one of them?

Â How do we use NPV, IRR and Payback Period to make this decision?

Â This is what we will cover in this video.

Â Let's look at an example.

Â The CEO of an FMCG firm is considering

Â Investing in a sophisticated analytics platform that'll

Â help its Product Development group create superior customer value propositions.

Â However, its Operations group suggests that

Â upgrading its supply chain is a better investment.

Â Given a constrained budget, how does the CEO decide between these two alternative.

Â We have some additional information on the two projects.

Â The Business Intelligence Platform will yield incremental profits of $1.56

Â million and $1.93 million respectively, in the two years following implementation.

Â Thereafter profits will settle at $1.96 million.

Â 1:11

Maintenance costs for this period are estimated at $180,000 a year.

Â The platform involves upfront hardware costs of $306,000,

Â software costs of $612,000 and training costs of $116.000.

Â On the other hand supply chain reengineering will

Â yield incremental profits of $2.5 million for

Â five years following the implementation of the technology.

Â Upfront implementation costs,

Â including those on training and consulting, are $1.6 million a year.

Â 1:42

Annual license and maintenance costs are $250,000.

Â Assume that the discount rate is 15% for

Â both investments, and that both projects will last for five years.

Â Let's calculate the NPV, IRR and the Payback Period of the two projects.

Â For the Business Intelligence Platform, the incremental revenue in the first year

Â is $1.56 million, in the second year it is $1.93 million, and

Â in each of years three to five it is $1.96 million.

Â The annual operating costs are $180,000,

Â which when subtracted from profits, yields cash flows of $1.38 million and

Â $1.75 million in years one and two respectively.

Â And cash flows of $1.78 million in each of the remaining years.

Â In addition the company needs to invest a total of $306,000 plus $612,000,

Â plus $116,000, which adds up to $1.034 million.

Â We can use the MPV function in Excel to calculate the present value of

Â these cash flows.

Â The MPV function takes the discount rate as its first input, and

Â then all the annual cash flows.

Â The first cash flow must be the year one cash flow and not the year zero cash flow.

Â Once we get the NPV of all future cash flows,

Â we can subtract out the year zero cash flows to get that NPV of the project.

Â The NPV function gives a value of $5.596 million.

Â 3:04

Subtracting the year zero cash flow of $1.034 million,

Â the Business Intelligence Platform has an NPV $4.562 million.

Â Using the IRR function in Excel with all the projects cash flows,

Â gives the project IRR of 147%.

Â Since the project requires an initial investment of $1.034 million,

Â and the first year's cash flows are $1.38 million,

Â it's Payback Period is less than one year.

Â Specifically, $1.38 million is generated in the entire year.

Â In what fraction of the year does the company recover $1.034 million?

Â We get the Payback Period by dividing $1.034 million by $1.38 million,

Â which gives us 0.75 years or nine months.

Â 3:48

Next, let's calculate the NPV, IRR, and

Â Payback Period of the supply chain reengineering or project.

Â It has annual revenues of $2.5 million for five years.

Â Its annual cost are $250,000.

Â Subtracting the cost from the revenues,

Â yields annual cash flows of $2.25 millions in the five years.

Â Using the NPV function on these five cash flows, yields a value of $7.542 million.

Â 4:14

Subtracting the year zero cost of $1.6 million,

Â use an NPV $5.942 million for the supply chain reengineering project.

Â Its IRR comes to 139%, and its Payback Period is $1.6 divided by $2.25.

Â Which is 0.71 years or approximately eight and a half months.

Â Next to the decision part.

Â Both projects have positive NPVs

Â as well as IRRs far greater than the hurdle rate of 15%.

Â The Payback Periods are also both less than one year.

Â In fact, they're almost identical.

Â So which project should the CEO choose?

Â The supply chain reengineering option has the higher NPV of $5.942 million,

Â when compared to the $4.562 million for the Business Intelligence Platform.

Â This says that supply chain reengineering adds more shareholder wealth

Â than the Business Intelligence Platform.

Â And hence the CEO should choose the supply chain reengineering project.

Â However the Business Intelligence Platform has a higher IRR of 147%,

Â which says that the CEO should select Business Intelligence Platform.

Â So NPV and IRR give us contradictory results.

Â Here we should go with what NPV tells us, as it tells us which project

Â adds more shareholder wealth at the given discount rate of 15%.

Â See the figure, at discount rates of less than around 125%,

Â the supply chain reengineering has the higher NPV.

Â But at discount rates above 125%,

Â the Business Intelligence Platform has the higher NPV.

Â But given that the discount rate is 15%,

Â supply chain reengineering has the higher NPV.

Â And hence the CEO should select it over the Business Intelligence Platform option.

Â Also, IRR is not necessarily appropriate when trying to compare two projects,

Â as the scale of the projects and/or the cash flow patterns may differ.

Â For example, doubling all cash flows of both projects

Â will not change the IRR of the two projects.

Â Whereas, it'll double the NPV of both projects.

Â For these reasons,

Â it is better to use NPV when selecting one project from among many.

Â While we have seen examples where we have used NPV,

Â IRR and Payback Period to accept or reject projects,

Â these methods have some drawbacks which we will discuss the next time.

Â [MUSIC]

Â