From the e-Activity, analyze the reasons why the short-term project that you have chosen might be ranked higher under the NPV criterion if the cost of capital is high, while the long-term project might be deemed better if the cost of capital is low. Determine whether or not changes in the cost of capital could ever cause a change in the internal rate of return (IRR) ranking of two (2) projects.
The NPV is based on the time valuation of the project. The mutually exclusive projects are considered and ranked as per the Net Present Value of the projects. The short-term projects in the mutually exclusive projects are considered more favorable because of the time value of the Net Present Value (NPV). The long-term projects are more sensitive to the cost of capital as compared to the short-term project. The higher NPV of the short-term projects is because of the time valuation. The returns earned earlier are better as the value of money declines with the passage of time. The cost of capital rate of reinvestment is assumed to be appropriate by the NPV model. The changes in the cost of capital affect the IRR of the project. The project becomes unfavorable when the project has to pay back more than it has borrowed. Thus, the project with greater IRR than the cost of capital is considered favorable and the one with lower IRR than the cost of capital is considered unfavorable (Osborne).
From the scenario, take a position for or against TFC’s decision to expand to the West Coast. Provide a rationale for your response in which you cite at least two (2) capital budgeting techniques (e.g., NPV, IRR, Payback Period, etc.) that you used to arrive at your decision.
I am in support of using the NPV and IRR as the evaluation techniques for projects by TFC. The Net Present Value (NPV) of the project measures the profitability of the project by using the present values of cash outflows and cash inflows and comparing them. The TFC has recorded an investment NPV of about $23 Million. It is an important and profitable measuring tool as it uses the goal of maximization of the intrinsic value of the company.
The decision to use IRR is also valid. The IRR indicated the yield, efficiency, and quantity of investment. The investment that is considered acceptable has a higher IRR than the cost of capital. TFC reported IRR of 11.84%, which is higher than the 10.9% cost of capital, making the decision acceptable to the company. Thus the expansion of the West Coast is a viable and financially favorable decision (Wnuk-Pel).
Work Cited
Osborne, M. J. “A resolution to the NPV-IRR debate?” The Quarterly Review of Economics and Finance 50.2 (2010): 234-239.
Wnuk-Pel, T. “Factors determining the selection of capital budgeting methods in companies operating in Poland.” Zeszyty Teoretyczne Rachunkowosci 84.140 (2015): 217.
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