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

Cases Finance Investment NPV profitability
New answer on Apr 11, 2020
3 Answers
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Anonymous A asked on Apr 10, 2020

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

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Luca
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replied on Apr 11, 2020
BCG |NASA |20+ interviews with 100% success rate| 120+ students coached |GMAT expert 780/800 score

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

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Anonymous replied on Apr 10, 2020

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

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Anonymous A on Apr 10, 2020

Hi Hugo, thanks for your answer. Let's say that my company is a large holding (no cash restrictions + possibility to make other investments). In this case, how can I consider the potential benchmark in this alternative investment choice. To me, the case should be: option1, I go with NPV2; option2, I go with NPV1 and use the extra cash for other investments. What's your take on this? :)

Anonymous on Apr 10, 2020

Let's put it that way: if there are no restriction I would recommend NPV2. Now if, and only if, there are alternative projects with higher NPVs that bring you to a similar "average", you can recommend NPV1. But again, I am just looking at it from an NPV perspective and with no investment horizon.

(edited)

Clara
Expert
Content Creator
replied on Apr 10, 2020
McKinsey | Awarded professor at Master in Management @ IE | MBA at MIT |+180 students coached | Integrated FIT Guide aut

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

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Luca gave the best answer

Luca

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