The crossover point is the rate at which the NPV of the two projects are equal. NPV has a direct relationship between NPV and Economic Value Added. The NPV shows how the shareholders’ wealth would be increased if the project is accepted. The goal of the company is to increase shareholders’ wealth, thus NPV shows the better way in choosing the right decision to achieve their goal. NPV method implicitly assumes that the rate at which cash flows can be reinvested is the cost of capital, whereas the IRR method assumes that the firm can reinvest at the IRR. NPV method is better because it selects the project that adds the most to shareholder wealth.
Tim can show that the MIRR is the more realistic measure to use in the case of mutually exclusive contracts by explaining that by using MIRR, they can avoid the multiple IRR problems and at the same time explain that since reinvestment at the cost of capital is generally more correct, the MIRR which assumes that CFs from all projects are reinvested at the cost of capital rather than on the project’s own IRR (in the case of IRR), is a better indicator of a project’s true profitability. Tim could also state that with the use of MIRR, the company can avoid some conflicts encountered when comparing NPV with IRR. With the use of MIRR, they can minimize the conflict between the two, just like when the two projects being compared have equal size and same life, both NPV and MIRR leads to the same decision. The company can also arrive at the same decision when the two projects being compared have equal size and different life.
Using Profitability Index can help in deciding which project to choose because it gives the ratio which allows us to measure the proportion of money returned to money invested. Thus by profitability index, it allows us to compare investment opportunities that requires us different initial investments. The higher profitability index will be chosen because it gives higher possible return in the amount that is to be invested. In short, in the dilemma of Day-pro, Synthetic Resin must be chosen because it gives a higher return in spite of the high initial investment. However, in using this method, the analyst will ignore many factors, such as risk, cost of capital, and liquidity of the project. Thus, the company must consider or decide first on what factor they will base their decision in choosing a project.
Being more conservative in revenue projection will give us an idea that the project is less liquid because they projected a longer period of time before the company can earn back the invested amount. Moreover, it also indicates that they considered the possible risks that may occur in the project along the way. The chance of overestimation and underestimation of the project is less possible that make it more realistic. Thus, the Synthetic Resin project is more reliable and accurate. Knowing that the synthetic resin would require extensive and longer time before it could be implemented, it will cause doubt on the part of the Board to choose this project because it only says that Synthetic Resin project is less liquid compared to epoxy resin and the company will be tied longer to this project before it can regain the invested capital.
However, looking at the other side of the coin, synthetic resin gives a higher return in spite of its flaws and its risks. On the other hand, Epoxy Resin seems to be more liquid and less risky and the return of this project is less compared to the Synthetic Resin. As a result, the board might be more attracted to Epoxy Resin. Still, the decision of the board depends on what they give importance or emphasis in choosing a project. And since the Board has a strong preference in using rates or return as its criteria, we would recommend to the Board to choose Synthetic Resin.
Courtney from Study Moose
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