A firm has a $100 million capital budget. It is considering two projects, each costing $100 million. Project A has an IRR of 20% and an NPV of $9million; it will be terminated after 1 year at a profit of $20 million, resulting in an immediate increase in EPS. Project B, which cannot be postponed, has an IRR of 30% and an NPV of $50 million. However, the firm’s short-run EPS will be reduced if it accepts Project B because no revenues will be generated for several years.
a. Should the short-run effects on EPS influence the choice between the two projects?
b. How might situations like this influence a firm’s decision to use payback?
If you were the CFO of a company that had to decide on hundreds of potential projects every year, would you want to use sensitivity analysis and scenario analysis as described in the chapter, or would the amount of arithmetic required take too much time and thus not be cost-effective? What involvement would nonfinancial people such as those in marketing, accounting, and production have in the analysis?