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IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects

A company ranks two mutually exclusive projects. Project X has the shorter payback period and the higher ARR, while Project Y has a higher NPV at the company's cost of capital. Which statement is the soundest guidance for the decision?

Choose Project Y. NPV uses all cash flows discounted at the cost of capital and so measures the value added for shareholders. Payback and ARR ignore later flows or the time value of money, so their conflicting rankings should not override NPV.

  1. AChoose X, because shorter payback always means higher shareholder value
  2. BChoose X, because ARR is based on reported profit
  3. CChoose Y, because NPV measures the value added in discounted cash termsCorrect
  4. DChoose neither, because the methods conflict
  5. Choose Y, because it must have the longer payback

Explanation

NPV uses all cash flows and discounts them at the cost of capital, so it measures the increase in shareholder wealth. Payback ignores timing within the period and later flows, and ARR uses accounting profit with no time value. Conflicts are normal and NPV is preferred. The claim that Y must have longer payback is not implied by the facts.

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