The main aim behind all financial management decisions is to maximize the value to the stakeholders and optimize the risk-return aspects of the business portfolio. In this case, the company is confronted with 3 projects. Projects X and Y have similar characteristics with the only difference of buying (in project X) and leasing (project Y). Project Z seeks to minimize the initial investment and hence the commitment of funds to the project.
The first rule applied is the payback period. This metric is lowest for project Z as it has payback of 2 years only while the other projects have payback periods of greater than 4 years. As such, project Z is the best option. However, this method does not consider the time value of money and is not highly informative. The second method of accounting rate of return also implies that project Z is the best as its return is highest at 44% while the other 2 projects have returns of less than 25%.
The Net Present Value (NPV) method is then applied as it considers the time value of money and all the cash flows associated with the project. As per this metric, project X is the best as its NPV of 22,404 is the highest. However, it is also important to consider that the initial investment of all the 3 projects are different. Therefore, the profitability index was computed which expresses the net present value as proportion of the initial investment. The profitability index was highest for project Z at 2.23 while it was less than 1 for both projects X and Y with values of 0.66 and 0.58 respectively. As such, it is suggested that project Z is the best option.
The Internal Rate of return (IRR) metric was also used to evaluate the projects and the highest value was obtained for project Z at 55%. This is much higher than the required return of 11.5% and therefore project Z is the best option. The biggest problem with this method is that it assumes that all the cash flows are invested at this rate and achieving this high return may be impossible for the company on all intermediate cash flows.
In short, it is concluded that project Z is the best project amongst these three mutually exclusive projects as it has the highest ranking on the basis of all metrics. Sensitivity analysis was conducted by varying the discount rate and the results were obtained the same as project Z generated positive net cash flow till rates as high as 55%. Apart from the financial numbers, the project seems to commercially sound since it requires optimal utilization of existing space and minimal upfront investment. This reduces the risk of the company also. However, it is important to note that the recommendations of this report highly depend on the accuracy of the inputs. If the cash flow pattern deviates significantly from the assumptions made, the profitability of the projects can vary significantly.