Question

You are working on the economics of a project you are considering. You have to prepare a presentation to the management team of the business on it. Your presentation will either recommend you go ahead because the economics look good or stop the project because the economics are unfavorable. Your analysis shows that the project has an NPV of MINUS $1 million and an IRR of 8%. Your company’s minimum acceptable return on capital is 10%. You think you know what your recommendation will be based on this result.

But a co-worker comes into your office and says he has a great way to improve the economics of a project! Your co-worker proudly says that all you need to do is to finance the project with 50% debt that is available at an interest rate of 5%. He is sure he can secure a loan for the life of the project at that low interest rate. He is also sure the economics (NPV and IRR) of the project will improve because of the effect of debt financing. Your reply should be:

1. The interest rate of the debt is below the IRR of the project so borrowing to do the project is a GREAT idea. You agree you need to factor the loan into your analysis and recommend that the management team go ahead with the project.
2. This is not a good idea, while the interest rate of the debt is below the IRR of the project you think it is best to assess the project on a debt free basis. You should present the economics free of any debt so the management team can see its IRR and NPV on that basis. Since the project does not look good on a debt free basis it is not a good idea to recommend it even though with debt financing its economics improve.

Answer 1

Internal Rate of Return (IRR): In the domain of capital budgeting IRR is a metric used to assess the profitability of potential investments.

Net Present Value (NPV): Is the present value of all future cash inflows and outflows of a company determined around a discount rate.

Note: When we equate formula for determining NPV to zero, the discount rate that is found represents the IRR for the investment.

The answer is: B

B. This is not a good idea, while the interest rate of the debt is below the IRR of the project you think it is best to assess the project on a debt-free basis. You should present the economics free of any debt so the management team can see its IRR and NPV on that basis. Since the project does not look good on a debt-free basis it is not a good idea to recommend it even though with debt financing its economics improve.

The values for NPV and IRR have been provided to us as (-) $ 1million and 8% respectively(An instance where IRR<NPV). With the general rule of hand, we know that an in investment with a negative NPV corresponds to the present value of costs being higher than the present value of revenues. On the other hand, the IRR of 8% is less than the required rate of 10%. Given these two metrics, the project should be abandoned.

In addition to this, an improvement in the economics of the project can be brought about by debt fuelling the project at an interest rate lower than the IRR (5%). However, the analysis of the project should be carried out exclusive of debt, this will aid in analysing the projects true worth. Furthermore, creating a liability on a project that is innately unimpressive is a bad decision.

Therefore, on a concluding note, the project should be analysed and assessed on a debt-free basis to arrive at a conclusion that accurately aligns with the objectives of the management.