Capital Budgeting

Consider six proposed investment plans, as illustrated in the table below. We have already calculated the NPV and payback period for each of these plans. Your task, as an analyst, is to analyze the implications of selecting or comparing these projects solely based on the payback period. Carefully examine the cash flow patterns, payback periods, and associated NPVs of each project. 

Project L: Project L has the shortest payback period among all the projects, but it comes with a negative NPV. Therefore, selecting this project based solely on its short payback period would be misleading, as it does not generate value for the company or its shareholders.

Comparing Project M with N: Both Project M and Project N have identical payback periods and net cash flows (NCF) after the payback period. On the surface, either project could be chosen based on the payback criteria. However, this would be an incorrect recommendation. The reason is that Project N has a higher NPV than Project M, as N's cash flows are more front-loaded, meaning it generates more value in the early years. Thus, despite similar paybacks, Project N is the better choice when considering the long-term value creation.

Comparing Project O with P: Project O has a shorter payback period than Project P, but Project P has a higher NPV. Here, the payback period rule would suggest Project O is the better option, while the NPV rule would recommend Project P. The decision in such cases depends on the company’s primary objectives. If the company is focused on recovering its investment quickly, Project O may be favored. However, if the company's priority is value maximization, Project P would be the preferred choice. Additionally, the company’s financial capacity and funding availability could influence the decision, as capital constraints may make the quicker payback of Project O more attractive.

Comparing Project O with Q: This comparison highlights a significant flaw in the payback period selection method. Although both projects have the same payback period, Project Q generates significantly higher NCFs after the third year. The payback period, however, does not account for these additional future cash flows, which is a critical factor for evaluating the long-term value of a project. This flaw shows that relying solely on the payback period can lead to poor decision-making, as it overlooks important value generated beyond the payback period.

Equipped with the understanding of the payback period’s limitations, you now need to provide your analysis to your boss. After he reviews your analysis, he requests an additional evaluation of a new investment proposal.

New Proposal: Your company has discovered a small oil field near the coast of Namibia, and it is estimated that developing the oil field will require an investment of $1,000 million. The associated cash flows (after tax) for this project are provided in the table below. Your boss wants to know what the maximum exposure for this project will be.

In most projects, the entire investment is not required upfront in a single lump sum. Capital is typically invested over a period of time. In large-scale oil and gas projects, capital spending occurs over several years before cash flows are generated. A key advantage for investors is that the project often begins generating cash even while the spending program is ongoing. This means the project can be initiated without the need for the entire capital investment upfront. Eventually, the project becomes self-funding, as the cash generated from the project is reinvested into its development, eliminating the need for additional external capital.

If we plot a cumulative net cash flow (NCF) curve, the initial phase will show negative cash flows, represented by the line below the x-axis. As the project starts to generate cash, the negative cumulative cash balance will gradually decrease, moving toward zero, and eventually turning positive.

The point where the cumulative NCF line crosses the x-axis represents the payback period, which we have already discussed. The point where the cumulative cash balance reaches its most negative value during the project is known as the Maximum Capital Exposure.

This figure indicates the maximum amount of cash that needs to be supplied by the investor throughout the life of the project. Although the investor may not need to supply the entire capital upfront, they must be prepared to cover the maximum capital exposure. This criterion is also crucial for assessing the risk and financial viability of the project, as it represents the maximum potential downside.

Understanding the maximum capital exposure is vital for proper scheduling and funding of the project. It is important to avoid situations where multiple projects reach their maximum exposure at the same time, as this could place significant strain on the company’s financial resources, particularly in terms of funding or debt management.

Which project is superior in terms of NPV? In terms of IRR? Which one should we select if we can choose only one of the two?

First, let us compute the Net Cash Flows (NCF), NPV, and IRR for both options. The table below summarizes the results of our calculations:

This illustrates a situation where the NPV of Project Alpha is lower than the NPV of Project Omega, yet the IRR of Project Alpha is higher than that of Project Omega. Such scenarios can occur in practice and may be challenging for many managers.

The focus is not on which project generates the highest NCF, as the management's decision criteria are based on NPV and IRR rather than NCF, due to the implications of the time value of money.

In such situations, it is advisable to select the project based solely on NPV criteria. NPV is considered the standard of investment criteria. When in doubt, go for NPV.

The rationale behind the preference for NPV is as follows. Each time a cash flow series is discounted, it is assumed that those cash flows can be re-invested at that rate. This is why they are discounted at that assumed rate. For any acceptable project, the NPV is positive, which also means that the discount rate used for discounting is less than the IRR. If not, then the NPV will be zero or negative. This implies that the assumption of reinvestment is more conservative than what the IRR suggests.

In the given example, the discount rate used is 10%, and the IRRs of the projects are 31% and 21%. The lower rate of 10% appears to be the most likely rate for reinvesting the cash flow. Therefore, decisions should be based on NPV if conflicting results are presented.

There is an additional aspect in this example.

If the NPV profile (NPV vs. discount rate) of the two projects is plotted, a 'cross-over' point can be observed. There exists a discount rate below which project Omega has a higher NPV than project Alpha. At a discount rate above this 'cross-over' discount rate, the NPV of project Alpha is higher than that of project Omega.

When the cost of capital is 10% (discount rate = 10%), project Omega is preferred. Project Omega's NPV remains advantageous over Project Alpha as long as the discount rate does not exceed 14.5%. Beyond this threshold, Project Alpha’s NPV surpasses that of Project Omega.

From the analysis, we can deduce that if the cost of capital for these two projects is below 14.5%, Project Omega should be selected. Conversely, if the cost of capital exceeds 14.5%, Project Alpha becomes the preferable option.

Consider another scenario often encountered with conflicting NPV versus IRR results.

Conflict due to project scales:

In the prior example, the two projects had the same initial investment (or scale). Now consider a third project, Beta, whose initial outlay is double that of Project Alpha (i.e., the two projects differ in scale). The cash flows, NCF, NPV, and IRR for Projects Alpha and Beta are presented in the tables below.

If these projects were not mutually exclusive, both would be acceptable. However, since these are mutually exclusive projects, only one can be accepted. The decision lies between undertaking a larger project with a higher Net Present Value (NPV) but lower Internal Rate of Return (IRR), or a smaller project with a lower NPV but higher IRR.

As in previous scenarios, the decision should be based on NPV, disregarding IRR. Therefore, project Beta should be selected over project Alpha. The same rationale applies as before. This example aims to illustrate situations where NPV and IRR may yield different project rankings. In this case, the primary cause of conflicting results can be attributed to the initial investment size, as subsequent cash flow patterns are similar.