Page 200 - DMGT521_PROJECT_MANAGEMENT

Unit 11: Project Cash Flow

The graph above indicates that STN should invest only in projects A, C and D. In this case, we Notes
know STN's optimal budget is $5,400,000.
There are two additional issues we need to discuss regarding a firm's choice of investment
projects: (1) choosing between mutually exclusive projects, (2) evaluating marginal projects, and
(3) risk adjustment.

1. Choosing between mutually exclusive projects: When a firm is faced with two mutually
exclusive projects, it will have two IOS schedules. Similarly, three mutually exclusive
projects will lead to three IOS schedules. When we plot the IOS schedules using the IRRs of
the projects, we cannot simply pick the mutually exclusive project with the highest IRR. A
firm is interested more in maximizing its value, and this can only be done by choosing the
project with the highest NPV rather than the highest IRR. If you remember from our
earlier discussion on capital budgeting decisions, a higher IRR does not always translate
into higher NPV for a project.
In order to pick the right project, the firm needs to find the NPVs of the mutually exclusive
projects. However, this cannot be done without knowing the marginal cost of capital. The
firm needs the MCC schedule to determine the marginal cost of capital (for each IOS
schedule). Once the marginal cost is determined, the firm can find the NPV for each
mutually exclusive project. The one with the highest NPV will be chosen.

2. Evaluating marginal project: So far, we have encountered projects with IRR either above
the MCC or below the MCC. In situations like this, it is very easy for the financial manager
to make the decisions: accept projects that have IRRs above the marginal cost of capital and
reject projects that have IRRs below the marginal cost of capital. This situation is depicted
in Scenario 1 in the following graph. In this particular situation, the firm will accept
Projects A and B, and reject Projects C and D.
However, what should the financial manager do if "part" of the project has an IRR above
the marginal cost of capital but the rest of it below the marginal cost? This situation is
depicted in Scenario 2 in the following graph. In this particular situation, part of Project C
has an IRR higher than the marginal cost of capital and part of it has an IRR below the
marginal cost of capital. If Project C is divisible (i.e. the firm can invest in all or parts of the
project), then the firm will invest only in the portion of Project C that has an IRR above the
marginal cost of capital.

Figure 11.5: Evaluation of Marginal Project in Scenario 1 and 2

IRR, WACC IRR, WACC
A A
B B
C C
D D
New New
Capital Capital
Scenario 1 Scenario 2

What if the project is not divisible? In that case, should it be rejected? The answer depends
on the project's average cost. We will illustrate that with an example.

Example: Suppose the marginal project considered by Microsoft has an IRR of 12%. We
know that the project has an initial cost of $100,000. The first $60,000 of the project can be
financed at a cost of 10%, and the last $40,000 at a cost of 14%. Should the project be accepted?

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