Investment Comparison with different up-front costs (NPV-based)

Question

Hey there,

I was recently asked to evaluate two investments and I was really unsure.

Scenario:
- Rate of return = 10%
- Investment 1: Up-front cost = 100K; Cash Flow = 17K per year (perpetual) --> NPV = 70K
- Investment 2: Up-front cost = 200K; Cash flow = 30K per year (perpetual) --> NPV = 100K

Doubt
Which one is better?

Investment 2
- Pros: NPV2 is higher
- Cons: higher capital required (probably not included in the formula, because we could assume that it's riskier and therefore it should have a higher 'r')

Investment 1
- Pros: higher profitability (17% v. 15%), lower capital requirements, lower risk
- Cons: lower NPV

Thank you for your support, looking forward to hearing your answers!

Dee

Answer 1

Hello,

This is a very interesting question. Before taking a decision it's fundamental to ask interviewer some questions:

What is the target of our client? It's more interested in an higher NPV or ROI? As you know, this would change the answer
What is our budget? You have to be sure that you can afford the second investment. For example, if you have to take out a loan, NPV could be significantly affected by the loan interests
Can we consider any alternative investment? Imagine that your budget is 200k€. Even in this case it's not given that is a good idea to invest 100k€ more to have a plus of 30k€ in your NPV. ANother option could be to choose the first option and use the other 100k€ for another investment with an NPV of 40k€. Considering your numbers this doesn't sound so difficult and it would also give you a risk diversification

Feel free to write me if you have any other question,
Hope it helps,
Luca

Answer 2

Hi Anonymous,

If you come up with those calculations and have two differents NPVs, the idea is to ask the client (or the interviewer) his goals right from the beginning of the case or along the case

If no specific goals mentioned, you can assume that the client wants to go for the highest NPV. So go with NPV2. This is the most common choice.
If the client has cash restrictions then you might want to go with NPV1
If your client has more qualitative goals, you might want to make your choice according to this. For instance, if your client does not have the capabilities to to Investment 1, then recommand to go with 2.

Again, the most important is to be clear with client's goals/KPIs as soon as possible in your case.

Hope this helps

Answer 3

Hello!

This is an excellent question to showcase how important it is to know WHAT IS SUCCESS for the client.

If you could only ask one question at the beggining of the case -actually, don´t worry, you can ask many-, it would need to be this one, and can be phrased in different ways:

What is success for the client?
What is the client´s target with this comparison?
Are there any metrics or KPIs that the client is particularly concerned about?

Like this, you would know precisely which is the key thing for the client and, once you have compared both -as I see you did already, and I agree with the reasoning-, you can choose.

Hope it helps!

Cheers,

Clara