The investment detective: can you rank the projects simply by

The essence of capital budgeting and resource allocation is a search for good investments in which to place the firm’s capital. The process can be simple when viewed in purely mechanical terms, but a number of subtle issues can obscure the best investment choices. The capital budgeting analyst is necessarily, therefore, a detective who must winnow good evidence from bad. Much of the challenges is knowing what quantitative analysis to generate in the first place.

Supposed you are a new capital budgeting analyst for a company considering investments in the eight projects listed in Exhibit 1. The chief financial officer of your company has asked you to rank the projects and recommend the “four best” that the company should accept.

Part I

For the first part of this assignment only quantitative considerations are relevant. No other project characteristics are deciding factors in the selection, except that management has determined that projects 7 and 8 are mutually exclusive.
All projects require the same initial investment, $2,000,000. Moreover, all are believed to be of the same risk class. The weighted average cost of capital for the first part is 10%. To simulate your analysis, consider the following questions:

1. Can you rank the projects simply by inspecting the cash flows?
2. What criteria might you use to rank the projects? Which quantitative ranking methods are better? Why?
3. What is the ranking you found by using quantitative methods? Does this ranking differ from the ranking obtained by simple inspection of the cash flows?
4. What kinds of real investment projects have cash flows similar to those in the exhibit?

 

 

EXHIBIT I     Project cash flows in (000)        
  Project1 Project2 Project3 Project4 Project5 Project6 Project7 Project8
Initial Investment  $   (2,000.00)  $    (2,000.00)  $    (2,000.00)  $  (2,000.00)  $     (2,000.00)  $     (2,000.00)  $    (2,000.00)  $   (2,000.00)
Year                
1  $        330.00  $     1,666.00    $       160.00  $          280.00  $      2,200.00  $     1,200.00  $       (350.00)
2  $        330.00  $        334.00    $       200.00  $          280.00    $        900.00  $         (60.00)
3  $        330.00  $         165.00    $       350.00  $          280.00    $         300.00  $           60.00
4  $        330.00      $       395.00  $          280.00    $           90.00  $        350.00
5  $        330.00      $       432.00  $          280.00    $           70.00  $        700.00
6  $        330.00      $       440.00  $          280.00      $     1,200.00
7  $        330.00      $       442.00  $          280.00      $    2,250.00
8  $     1,000.00      $       444.00  $         280.00      
9        $       446.00  $          280.00      
10        $       448.00  $          280.00      
11        $       450.00  $          280.00      
12        $       451.00  $          280.00      
13        $       451.00  $          280.00      
14        $       452.00  $          280.00      
15      $  10,000.00  $  (2,000.00)  $          280.00      
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