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

In 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 firms 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.)

1. Rank the projects by inspecting cash flows:
   1. Rank the investments based on the payback period (as indicated in the given case data).
   2. Rank the investments based on the undiscounted excess of cash flow over initial investment as given in the case data.
   3. Calculate the Average Return on Investment. Average ROI is something that can be used in place of ROI or Simple Rate of Return when cash flows vary from year to year. In this case, calculate Average ROI as the average of the cash flows over the life of the project divided by the projects initial investment.
   4. Based on the three analyses above, which projects appear the best? What concerns do you have using these methods?

Exhibit 1 The Investment Detective Projects' Free Cash Flows (dollars in thousands) Project number: Initial investment $(2,000 $(2,000) 2,000) $(2,000) 2,000) $(2,000) 2,000) (2,000) $ 1,666 334 165 330 330 330 330 330 330 330* $ 1,000 Year S 160 280 2,200$1,200 (350) (60) 350 1,200 395 432 90 70 280* 450 451 451 452 12 13 15 10,000* $(2,000) 280 Sum of cash flow benefits $ 3,310 2165 $10,000 3,561 $4,200 $2,200 2,560 $4,150 Excess of cash flow over 1,310 165 8,000 1,561 $2,200 S 200 560 $2,150 nitial investment Indicates year in which payback was accomplished