Consider the following scenario:
You have just inherited a small island in the Bahamas. The island is near a favourite fishing location, and you are considering two alternative investments.
- First, you could construct a boat landing that provides grounds for camping. You estimate that the landing will require a £1,000 investment today and that it is expected to generate cash flows of £1,000 per year, forever.
- Alternatively, you could invest £10,000 today and build a restaurant and ‘beer garden’, which you believe will then generate cash flows of £4,000 per year, forever.
You cannot undertake both businesses on the island (they are mutually exclusive), and since both rely on tourists, you believe that the riskiness of each venture is identical (you may assume this to be the case and that the associated required return is 20%).
A quick calculation shows that the IRR of the first alternative is 100% and that the IRR of the second alternative is 40%. Hence, according to the IRR criterion, the first option is preferable.
For your Initial Response, in approximately 750 – 1,000 words, address the following:
- Do you agree with the assessment?
- Provide alternative capital budgeting evaluations of the two projects and discuss which method is the most reliable.
- Also discuss what other factors should be taken into consideration. Be sure to articulate the strengths and weaknesses of each technique.