Review the data of Case 16 "The Investment Detective". Utilize various methods to determine the ranking of the projects based on the cash flows provided. Be certain to use NPV and IRR calculations in your analysis. Then, complete the same analysis with a higher discount rate using the same evaluation methods.
Why do the rankings become more stable and similar between the 2 methods with a higher discount rate? Explain with example from your work.
Page 239 CASE 16 The Investment Detective 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 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: the first place. Exhibit 16.1. The CFO of your company has asked you to rank the projects Suppose you are a new capital-budgeting analyst for a company considering investments in the eight projects listed and recommend the "four best" that the company should accept 7 Project number: Initial investment 1 2 5 3 4 6 8 $2,000) $(2,000) $2,000) $(2,000) $2,000) $2,000) $(2,000) $2,000) $ 1.200 $ 350) $ 280 $330 160 Year 1 $1,666 $ 2,200 334 330 200 280 900 60 165 90 330 395 432 280 280 350 330 70 700 1,200 $2,250 330 280 440 $1,000 444 280 446 280 280 448 12 451 280 13 451 280 452 280 $10,000 $2,000) 280 Sum of cash $3,310 $2.165 $10.000 3,561 $4,200 $2,200 $2.560 $4,150 flow benefits Excess of cash flow over initial invostmont S 165 $ 200 $ 8,000 $ 560 $2,150 1,310 $1,561 $2,200 EXHIBIT 16.1 | Projects' Free Cash Flows (dollars "indicates year in which payback was accomplished. thousands 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 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). Page 239 CASE 16 The Investment Detective 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 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: the first place. Exhibit 16.1. The CFO of your company has asked you to rank the projects Suppose you are a new capital-budgeting analyst for a company considering investments in the eight projects listed and recommend the "four best" that the company should accept 7 Project number: Initial investment 1 2 5 3 4 6 8 $2,000) $(2,000) $2,000) $(2,000) $2,000) $2,000) $(2,000) $2,000) $ 1.200 $ 350) $ 280 $330 160 Year 1 $1,666 $ 2,200 334 330 200 280 900 60 165 90 330 395 432 280 280 350 330 70 700 1,200 $2,250 330 280 440 $1,000 444 280 446 280 280 448 12 451 280 13 451 280 452 280 $10,000 $2,000) 280 Sum of cash $3,310 $2.165 $10.000 3,561 $4,200 $2,200 $2.560 $4,150 flow benefits Excess of cash flow over initial invostmont S 165 $ 200 $ 8,000 $ 560 $2,150 1,310 $1,561 $2,200 EXHIBIT 16.1 | Projects' Free Cash Flows (dollars "indicates year in which payback was accomplished. thousands 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 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)
