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The given data in the question is shown as following:
|Expected Sale Price in Year 5|
Mutually exclusive investment
The term mutually exclusive investment usually involves several competing mutually exclusive projects which refer to those which compete with other projects in such a way that the acceptance of one will automatically exclude the possibility of accepting other alternatives at the same time (Khan 2004, p. 10). For example, if the company chooses the first investment option, the KCC Pearl, then it at the same time it means that the company could not choose other investment options.
Time value of money
The term time value refers to the belief that a dollar in hand today is worth more than a dollar promised at some future time (Magoon & Vasishth 2007). And because of the time value, people believe that at the future money need to be discounted according to how far it is expected. For example, KCC Pearl’s residual value is $18,000,000 in the year 5, then the current value of this salvage value should be discounted to present.
Discount rate is the rate of return used to convert future values to present values (Bygrave & Zacharakis 2004, p. 458). In this case, the calculation of the present value for projects, KCC Pearl, Sea View and Mountain View will adopts the discount rate of 15% while the rest will use 8% instead.
Calculations – Internal rate of return (IRR)
Because the Internal rate of return (IRR) makes the net present value of all cash flows from a particular project equal to zero, therefore, the calculation is as following:
Calculations – Net present value (NPV)
Calculations – Profitability index
We use this formula: Profitability index = PV of future cash flow / Initial investment
|PV of future cash flow||Initial investment||Profitability index|
Let’s review the results of the above three kind of calculations:
|Options||IRR||NPV||Profitability index||Initial investment||Budget||NPV of the option + unused budget money|
I will recommend option “sea view” because of the largest NPV which is much higher than those of the rest, suggesting that this option bring in more present value than others after taking into consideration of the time value. Also the IRR is not the lowest and the Profitability index is fair as well. Another important reason that I will recommend this option is that it takes up $15,000,000 out of the budget $ 18,000,000 indicating that this project has a better use of the budget if these six options are mutually exclusive investments which means that KP could only choose one of these options and give up the others. But one uncertainty that that we have not taken into account is the unused budget money which could still be used in other purposes or at least could be put in the banks. Therefore, we calculate again the NPV of the option plus unused budget money, Sea View is among the top two scores, therefore, I will insist the Sea view options as it makes a better use of the budget and provides the maximized NPV.
If the budget is only $12,000,000 instead, then option “sea view” will be excluded while the rest options are still available. But the profitability index method could not longer be used in this evaluation process as a good indicator because the profitability index does not take investment amount into consideration and therefore can not be used when the investment amount is limited.
In this case, let’s review the rest calculations:
|Options||IRR||NPV||Initial investment||Budget||NPV of the option + unused budget money|
Under the changed conditions, I will recommend the Hill Top option which has the highest IRR suggesting that the project has a good growth rate and also the Initial investment is low providing more cash in hand for KP strengthening its financial health though the disadvantage is that its NPV is lower than those of Mountain View Northern Giant, it is still fare. Hence, I will recommend the Hill Top option.