Question

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, therefore, is necessarily a detective who must winnow bad evidence from good. Much of the challenge is in knowing what quantitative analysis to generate in the first place.

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

In this assignment, only the 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 the projects require the same initial investment, $2 million. Moreover, all are believed to be of the same risk class. The firm’s weighted average cost of capital has never been estimated. In the past, analysts have simply assumed that 10% was an appropriate discount rate (although certain officers of the company have recently asserted that the discount rate should be much higher).

To stimulate your analysis, consider the following questions:

Can you rank the projects simply by inspecting the cash flows?

What criteria might you use to rank the projects? Which quantitative ranking methods are better? Why?

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?

What kinds of real investment projects have cash flows similar to those in Exhibit1?

Find at these 4 different discount rates: 10%, 11%, 12%, and 14%

Exhibit 1

Project Number		1	2	3	4	5	6	7	8
Initial Investment		($2,000)	($2,000)	($2,000)	($2,000)	($2,000)	($2,000)	($2,000)	($2,000)
Year   1		$330	$1,666	$0	$160	280	$2,200	$1,200	($350)
2		330	334	0	200	280	0	900	(60)
3		330	165	0	350	280	0	300	60
4		330	0	0	395	280	0	90	350
5		330	0	0	432	280	0	70	700
6		330	0	0	440	280	0	0	1,200
7		330	0	0	442	280	0	0	2,250
8		1,000	0	0	444	280	0	0	0
9		0	0	0	446	280	0	0	0
10		0	0	0	448	280	0	0	0
11		0	0	0	450	280	0	0	0
12		0	0	0	451	280	0	0	0
13		0	0	0	451	280	0	0	0
14		0	0	0	452	280	0	0	0
15		0	0	10,000	(2,000)	280	0	0	0
Sum of Cash Flow Benefits		$3,310	$2,165	$10,000	$3,561	$4,200	$2,200	$2,560	$4,150
Excess of Cash Flow
Over Initial Investment		$1,310	$165	$8,000	$1,561	$2,200	$200	$560	$2,150

Answer 1

A capital budgeting decision is taken after proper analysis of the cashflow from the projects under consideration. Capital budgeting uses various methods such as 1. payback period, 2. Profitability Index (PI), 3. NPV, 4. IRR to evaluate the project cashflows and the projects are ranked based on their performance. Simply by inspecting the cash flow, it is not possible to take the right decision.

Out of the above mentioned methods, most appropriate are the ones that considers the time value of money or the present value of money. The methods like PI, NPV and IRR, all takes into account the time value of money.

Let us use these methods to make the ranking of these projects:

From the above ranking it can be seen that different projects being selected under different methods.

The 4 projects selected based on Ranking are Project, 3,4, 5 and 8.