1.

OBJECTIVES:

The objective of this case is to explore the ranking differences that may result from using the PI,
NPV, and IRR evaluation techniques. It illustrates the time disparity, size disparity, and life
disparity problems and the appropriate approaches to the resolution of these problems. This case
works is a practical problem coinciding with the introduction of project ranking and capital-
rationing material.

2. ORGANIZATION AND MANAGEMENT TEAM:

This is private organization founded by Robert L. Harding in 1962. The main business thus
organization is doing production of plastic parts and molding for automakers.

For capital investment decision, This Company has management team which consist three
members. Among of these ; have company president Mr. Harding, Susan Jorgensen who is
comprotoller of this company and lasty Mr.Chiris woelk who are responsible for R&D
department of this company.

3. AVAILABLE PROJECTS:

Currently management team is working four set of project which is consisting eight individual
projects. These entire projects are profits projects though in earlier time company invested in
Research & development project as well as safety assurance projects.

Initial Outlay CF in Year 1 CF in Year 2 CF in Year 3

Project A (75,000) $10,000 $30,000 $100,000

Project B (75,000) $43,000 $43,000 $43,000

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 Initial Outlay CF in Year 1
Project C (8,000) $11,000
Project D (20,000) $25,000

Initial CF in CF in CF in CF in CF in CF in CF in CF in CF in CF in
Outlay Year Year Year Year Year Year Year Year Year Year
1 2 3 4 5 6 7 8 9 10
Project ($30,000) $210,0
E 00
Project ($271,500 $100,0 $100,0 $100,0 $100,0 $100,0 $100,0 $100,0 $100,0 $100,0 $100,0
F ) 00 00 00 00 00 00 00 00 00 00

CF in CF in CF in CF in CF in CF in CF in CF in CF in
Initial
Year Year Year Year Year Year Year Year Year
Outlay
1 2 3 4 5 6 7 8 9
Proje ($500,0 $225,0 $225,0 $225,0 $225,0 $225,0
ct G 00) 00 00 00 00 00
Proje ($500,0 $150,0 $150,0 $150,0 $150,0 $150,0 $150,0 $150,0 $150,0 $150,0
ct H 00) 00 00 00 00 00 00 00 00 00

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4. ANSWERS TO QUESTIONS:

Based each question, answer are given corresponding below with details calculation and
explanation.

Q1: Was Harding correct in stating that NPV, PI and IRR necessarily will yield the same ranking
order? Under what situations might the NPV, PI and IRR methods provide different rankings?
Why is it possible?

Answer: Although all methods might grant projects acceptable ratings, NPV, PI, and IRR will
not necessarily yield the same ranking order. Such a phenomenon is the result of different cash
inflows over time (projects A and B), time horizons (projects E and F) and/or project sizes
(projects C and D). No. While, in general, it is true that when one discounted cash flow method
(NPV, PI, or IRR) gives a project an acceptable rating, the other two methods also give this
project an acceptable rating; it is not necessarily true that these discounted cash flow methods
will rank these acceptable projects in the same order. Ranking differences may occur as a result
of (a) the time disparity problem resulting from differences in the cash inflow patterns over time
between two projects; (b) the size disparity problem, resulting from the comparison of projects
requiring initial cash outflows of differing size; or (c) the life disparity problem, resulting from
projects with differing lives. These problems are illustrated in the case with Projects A and B
representing the time disparity problem, C and D, the size disparity problem, and with E, F, G,
and H, the life disparity problem. The ranking problems incurred using the discounted cash flow
methods are generally a function of the different assumptions made about the reinvestment
opportunities for cash inflows over the life of the project.

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Q2: What are the NPV, PI and IRR for projects A and B? what has caused the ranking conflicts?
Should project A or B be chosen? Might your answer change if project B is a typical project in
the plastic molding industry?

Answer:

Project A: Project B:
NPV = $34015..40 NPV = $31932.40
PI = 1.4535 PI = 1.4258
IRR = 27.194% IRR = 32.919%

In this case, the ranking conflicts have come as a result of different assumptions made as to the
reinvestment opportunities available for cash inflows over the life of the project. The NPV and
PI methods assume they can be reinvested at the IRR rate. Thus, the correct investment decision
as to acceptance of project A or Project B becomes a function of which assumption is more
accurate. When the reinvestment rate is unknown, the more conservative approach is to use the
net present value criterion as it uses the required rate of return as its reinvestment rate. Since no
project will be accepted returning less than this value, this must be at least a minimum
reinvestment rate, and, for this reason, is preferred. Here project A should select as it has a
higher NPV. If however, project B is a typical project, its IRR of 33% becomes a good
approximation for the reinvestment rate for ranking purpose, and Project B should then be
selected as the IRR assumption now appears more valid. Finally, if it is true that HPMC projects
typically yield approximately 12%, then the 33% IRR of project B is somewhat overstated for
ranking purpose.

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Q3: What are the NPV, PI and IRR for projects C and D? Should Project C or D be chosen?
Does your answer change if these projects are considered under a capital constraint? What return
on the marginal $12000 not employed in project C is necessary to make one indifferent to
choosing one project over the other under a capital rationing situation?

Answer:

The formula of
NPV: Cash flow [1- {1/ (1+k) ^n}]/k Initial Outlay

IRR for each year cash flow: Cash flow/ (1+k) = Initial Outlay

Profitability Index (PI): Present value of cash flow/Initial outlay

So, NPV, IRR & PI of project C & D are-

Project NPV IRR PI

(k=10%, n=1)
C 2000 37.5% 1.25
D 2727 25% 1.14

Project D should be chosen as it provides higher NPV than project C.

Under the situation of capital constrain it is better to choose project C though its NPV is less than
project D. In project C
Internal Rate of Return (IRR) > Discount rate K. and
Profitability Index (PI) is greater than 1 and higher than Project D.

These indicates that under the situation of capital constrain project C will generate more profit
than project D in spite of its lower NPV. So, project C will be chosen under a capital constrain.

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If marginal $12000 employed in project C as Initial outlay than

Project NPV IRR PI

C -2000 -8.3% 0.833

Under a capital rationing situation, project that generates higher profit within budget has to be
chosen. If marginal $12000 employed than project C will generate negative NPV, IRR< K and
PI<1. In this condition project D will be chosen over project C.

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 Q4: What are the NPV, PI and IRR for projects E and F? Are these projects comparable even
though they have unequal lives? Why? Which project should be chosen?

Answer:

Initial CF in CF in CF in CF in CF in CF in CF in CF in CF in CF in
Outlay Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

210,000- 210,000- 210,000- 210,000- 210,000- 210,000- 210,000- 210,000- 210,000-

Project E ($30,000) 30,000= 30,000= 30,000= 30,000= 30,000= $ 30,000= 30,000= 30,000= 30,000= $210,000
$ 180,000 $ 180,000 $ 180,000 $ 180,000 180,000 $ 180,000 $ 180,000 $ 180,000 $ 180,000

Project F ($271,500) $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000

NPV Calculation:
NPV of Project E= (180,000/1.1) + (180,000/1.1^2) + (180,000/1.1^3) + (180,000/1.1^4)
+ (180,000/1.1^5) + (180,000/1.1^6) + (180,000/1.1^7) + (180,000/1.1^8)
+ (180,000/1.1^9) + (210,000/1.1^10) 30,000
=$ 1,087,588

NPV of Project F= 100,000 [1-1/1.1^10]/.1 -217,500

=$ 342,958

As per NPV project E should be chosen as the NPV is higher.

IRR Calculation:

Project E:
(180,000/k) + (180,000/k^2) + (180,000/k^3) + (180,000/k^4) + (180,000/k^5) + (180,000/k^6)
+ (180,000/k^7) + (180,000/k^8) + (180,000/k^9) + (210,000/k^10) = $ 30,000
Suppose, k1=15%, L.H.S= $ 910,794
Suppose, k2= 20%, L.H.S= $ 776,157

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IRR of Project E= .15+ [{(30,000-910,794)/ (776,157- 910,794)}/(.2-.15)] = 32.71%

Project F:
100,000 [1-1/(1+k)^10]/k = $ 271,500
Suppose, k1=15%, L.H.S= $ 501,877
Suppose, k2= 20%, L.H.S= $ 419,247
IRR of Project F= .15+ [{(271,500- 501,877)/ (419,247- 501,877)}/(.2-.15)] = 28.94%

As per IRR Project E should be chosen as the IRR is higher.

Profitability Index Calculation:

Profitability Index of Project E= 1,117,588.38/ 30,000 = 37.25

Profitability Index of Project F= 614,458/ 271,500 = 2.26
As per IRR Project E should be chosen as the IRR is higher.

Projects NPV IRR PI

Project E $ 1,087,588 32.71% 37.25
Project F $ 342,958 28.94% 2.26

Initially the projects are not comparable as Project E has a lifespan of 1 year, whereas Project F
will continue for 10 years. In such circumstance, the NPV, IFF and Profitability Index are not
comparable. Since Project E earns its cash inflow of $ 210,000 at the end of the Year 1, while in
Project F has same cash inflow of $ 100,000 for next ten years, it has been argued that the
appropriate comparison is with the cash flow of the earlier project repeated ten more times. Thus
both the projects become comparable and the best project can be chosen, based on NPV, IRR and
Profitability Index.

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Q5: What are the NPV, PI and IRR for projects G and H? Are these projects comparable even
though they have unequal lives? Why? Which project should be chosen?

Answer:

For project G:
i). We know that, PV Annuity = C*(PVIFA)
= C {[1-(1/ (1+i)n)]/i}
So, NPV= C {[1-(1/ (1+i)n)]/i}-IO
NPV=225000{[1-(1/(1.1)5]/.1}-500000=352927

ii). Profitability Index (PI)

PI= C {[1-(1/ (1+i)n)]/i}/ IO

PI=225000{[1-(1/(1.1)5]/.1}/500000
PI=1.71

iii). Internal rate of return(IRR)

IRR: C {[1-(1/ (1+i)n)]/i}= IO

IRR: 225000{[1-(1/(1+i)5)]/i}=500000
At, K=15%, L.H.S of equation,
=225000{[1-(1/(1.15)5]/.15}
=754234

At, k=20%, L.H.S of equation,

=225000{[1-(1/(1.2)5]/.2}
=672887
IRR = 15% + ((500000-754234)/(672887-754234))*(20%-15%)
IRR=30.61%

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For project H:

i). Net present value (NPV)

We know that, PV Annuity = C*(PVIFA)
= C {[1-(1/(1+i)n)]/i}
NPV= C {[1-(1/(1+i)n)]/i}-IO
NPV=150000{[1-(1/(1.1)9]/.1}-500000=363853

ii). Profitability Index (PI)

PI= C {[1-(1/(1+i)n)]/i}/ IO
PI=150000{[1-(1/(1.1)9]/.1}/500000
PI=1.73

iii). Internal rate of return (IRR)

IRR: C {[1-(1/(1+i)n)]/i}= IO
IRR: 150000{[1-(1/(1+i)9)]/i}=500000
At, k=15%, L.H.S of equation,
=150000{[1-(1/(1.15)9]/.15}
=715737

At, k=20%, L.H.S of equation,

=150000{[1-(1/(1.2)9]/.2}
=604645
IRR=15% + ((500000-715737)/(604645-715737))*(20%-15%)
IRR=24.71%

Yes, those projects are comparable even though they have unequal lives.

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 Project G Project H
NPV 363853 352927

IRR 24.71% 30.61%

PI 1.73 1.71

(H-G) OF NPV=363853-352927=10926

Year Project H Project G Cash flow ( H- G )

0 -500000 -500000 0
1 150000 225000 -75000
2 150000 225000 -75000
3 150000 225000 -75000
4 150000 225000 -75000
5 150000 225000 -75000
6 150000 150000
7 150000 150000
8 150000 150000
9 150000 150000

IRR: -75000{[1-(1/(1+i)5)]/i}+ 150000{[1-(1/(1+i)4)]/i}*(1*(1+k)^5)

At, k=5%,
IRR: -75000{[1-(1/(1+.05)5)]/.05}+ 150000{[1- (1/(1+.05)4)]/.05}*(1*(1+.05)^5)=92041
At, k=10%,
IRR: -75000{[1-(1/(1+.1)5)]/.1}+ 150000{[1-(1/(1+.1)4)]/.1}*(1*(1+.1)^5)=10927
IRR= 5% + ((0-92041)/(10927-92041))*(10%-5%)
IRR=10.67%

Project H should be chose.

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5. CONCLUSION:
According to available method we analysis projects, measure NPV, PI and IRR to evaluated
project acceptability at first. In this analysis, we found different parameter value for each set of
project. As the each project have individual characteristics; and for this reason we couldnt
prioritize one single project as a ranking one or consecutively second. After a completed scenario
this has been possible to do rank these profitable projects. In our case, we have done this analysis
thoroughly and ranked each project as per result we have got in different evaluation techniques.

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