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: 1. Can you rank the projects simply by inspecting the cash flows? 2. What criteria might you use to rank the projects? Which quantitative ranking methods are better? Why? 3. 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? 4. What kinds of real investment projects have cash flows similar to those in Exhibit 1? Project number: Initial investment Year 2 79011LAUAWN- 4 6 8 1 $(2,000) $ 330 330 330 330 330 330 330* 12 2 $(2,000) $ 1,666 $1,000 13 14 15 Sum of cash flow benefits $ 3,310 $ 2,165 Excess of cash flow over initial investment $1,310 $ 165 * Indicates year in which payback was accomplished. 334* 165 Exhibit 1 The Investment Detective Projects' Free Cash Flows (dollars in thousands) 3 4 5 $(2,000) $(2,000) $(2,000) $ 160 $ 280 200 280 350 280 395 280 432 280 440* 280 442 280 444 280* 446 280 448 280 450 280 451 280 451 280 452 280 $(2,000) $ 280 $ 3,561 $4,200 $ 1,561 $2,200 $10,000* $10,000 $ 8,000 6 $(2,000) $ 2,200* $2,200 $ 200 7 $(2,000) $ 1,200 900* 300 90 70 $ 2,560 $ 560 8 $(2,000) $ (350) (60) 60 350 700 1,200 $2,250* $4,150 $2,150