Question 4.1 – Investment Decisions for Mutually Exclusive Projects
Imagine that a corporation has to decide between two mutually exclusive investment opportunities. Both require the same initial investment of $10 million. Investment “A” will generate $2 million per year (starting at the end of the first year) in perpetuity. Investment “B” will generate $1.5 million at the end of the first year and its revenues will grow at 2 percent per year for every year after that. The general question is then which of the two projects should the corporation undertake? The one with the highest internal rate of return (IRR)? Or the one with the higher net present value, given that the discount rate is 7 percent. Maybe the incremental IRR rule allows one to choose between the two investment opportunities. Or is the payback period rule able to provide an answer here? In order to make a proper investment decision, provide an answer to the following questions:
– What is the payback period for investment opportunity A and B?
– What is the IRR of the investment opportunity A and B?
– What is the incremental IRR of investment opportunity A and B?
– What is the NPV of investment opportunity A and B?
– Prepare an Excel spreadsheet where you plot the NPV of investment opportunity A and B for different discount rates. Assume the possible discount rate range is between 5.00 and 25.00 percent.
– Prepare in the similar Excel spreadsheet a plot of the value of the incremental project (A minus B) for different discount rates. Assume a similar discount range as in the previous exercise.
Hint: the incremental project (A minus B) is a “new” project where you subtract the value of project B from the value of project A. Here you assume you go long in project A and short in project B.