Case Study

The Investment Detective

The essence of capital budgeting and resource allocation is a search for good investments in which to invest the firms 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:

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 the exhibit?

Part II

The company has the following capital structure:

Account	$	Costs before tax
Long-Term Debt	1,500,000	10%
Preferred Stock	500,000	12%
Common Stock	3,000,000	20%

Calculate the weighted average cost of capital (tax is 40%)

Using the same cash flows in exhibit I find the NPV, PI,IRR and MIRR (Use your answer on part one as cost of capital). Which project(s) would you recommend and why?

Part III

Based on the following information and data in part II prepare Performa income statement. Also, calculate the DOL, DFL, and DTL and earning per share.

Q=20,000 units

Price=$120

VC=$80

Fixed cost=$450,000

100,000 outstanding shares

Assume that the management has a target DTL of 6. How much debt needs to be retired (replace by common stocks) in order to achieve that goal? What would be the new WACC?

Exhibit Project cash flows in (00)

	Project1	Project2	Project3	Project4	Project5	Project6	Project7	Project8
Initial Investment	$2,000	$2,000	$2,000	$2,000	$2,000	$2,000	$2,000	$2,000
Year
1	$330	$1,666		$160	$280	$2,200	$1,200	$(350)
2	$330	$334		$200	$280		$900	$(60)
3	$330	$165		$350	$280		$300	$60
4	$330			$395	$280		$90	$350
5	$330			$432	$280		$70	$700
6	$330			$440	$280	$4,000		$1,200
7	$330			$442	$280			$2,250
8	$1,000			$444	$280
9				$446	$280		$2,000
10		$5,000		$448	$280
11				$450	$280
12				$451	$280
13				$451	$280
14				$452	$280
15			$9,000	$(2,000)	$280
Sum of Cash Flow
Benefits	$3,310	$7,165	$9,000	$3,561	$4,200	$6,200	$4,560	$4,150
Excess of cash flow
Over investment	$1,310	$5,165	$7,000	$1,562	$2,200	$4,200	$2,560	$2,150

Yellow/italics indicate year in which payback is accomplished