question archive The essence of capital budgeting and resource allocation is a search for good investments in which to place the firm’s capital
The essence of capital budgeting and resource allocation is a search for good investments in which to place the firm’s capital
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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?
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 | |
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Answer:
1. Yes, project can be ranked by simply observing the cash flows using Payback period method but it does not consider time value of money. It is clear from the payback period Project 6 is best and Project 3 is worst. Ranking just only on the basis of only cash flows wil not give correct anaysis
| Project | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
| PB | 6.06 | 2 | 9.2 | 6.05 | 7.14 | 0.909 | 1.88 | 6.04 |
2. The ranking criteria should take into consideration time value of money as cash flows are not generated at the time of occuring. Therefore, we need to discount future cash flows.
As per NPV, project 3 is the best and project 8 is worst with least NPV.
3. the ranking you found by using quantitative methods are as follows:-
We could see that the ranking obtained from each of the four quantitative
methods is different with ranking obtained from simple inspection of the cash
flows
4.
Project 1 - It is one that is very similar to the investment in a coupon bond.
Project 2 - It is likely to venture capital project where there is large cash inflow that may occur at the end.
Project 3 - It has a zero coupon bond where you can buy the bond at a specific price and able to receive a large cash outflow towards the end of the maturity period.
Project 4 - Could possibly generate the most positive cash, and possibly even sell it in return to get more cash.
Project 5 - Is the most similar to getting an annuity
Project 6- Has the same outcome as project 2
Project 7 and 8Has the same outcome as project 4
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