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Many investment criteria commonly used in the past have not provided very effective guidance for spending investment dollars most efficiently. Discounted cash flow techniques, such
Many investment criteria commonly used in the past have not provided very effective guidance for spending investment dollars most efficiently. Discounted cash flow techniques, such as present worth and internal rate of return, represent improvements over some of the simpler measures and are becoming widely accepted, though perhaps not always understood. In capital-budgeting situations, where one suffers funds limitations, even present worth and internal rate of return fall short of what the decision maker needs. Neither will give proper comparisons among projects. Productivity index and growth rate provide ranking measures that can help in maximizing the worth of the firm by making sure the best projects get to the top of the list To illustrate the problems that confront people in capital allocation, let us dream up some independent projects with greatly differing cash-flow patterns (see table below). We then calculate several of the well-known economic indices and see what they lead to. To simplify, assume that each of the 11 projects requires only one investment, and that is required at time zero. Further, each project will be considered as having a 10-year length. Calculate discounted pay-back period (at three discount rates), internal rate of return, present worth (at three discount rates),growth rate of return (at three discount rates), and profitability index (at three discount rates). We have only $3,000 and must choose among these 11 projects. We would need a full $10,000 to get into all the investments, so clearly we must find some way to decide which projects merit our attention for the cash at hand. Rank all projects based on different yardsticks, then select the best projects based on your budget. Discuss your selection preferences based on advantage and drawbacks of different criterion (The three discount rates are: 5%, 10%, and 15%)
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