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 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:

$1.$ 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 the exhibit?

Part II

The company has the following capital structure:

Account $ Costs before tax

Long$-$term Debt $2,000,00010\%$

Preferred Stock $500,00014\%$

Common Stock $2,500,00018\%$

$1.$ Calculate the weighted average cost of capital $($tax is $36\%)$

$2.$ Using the same cash flows in exhibit I find the NPV$,$ PI$,$ IRR. Which project$($s$)$ would you recommend and why?

Part III

Based on the following information prepare Performa income statement. Using the data, calculate the DOL, DFL and DTL$.$

Q $=20,000$ units

Price $=$ $$120$

VC$=$ $$80$

Fixed cost $=$ $$400,000$

Interest $=$ $$200,000$

Dividend$=$ $$70,000$

EXHIBIT I Project cash flows in $(000)$

Project$1$ Project$2$ Project$3$ Project$4$ Project$5$ Project$6$ Project$7$ Project$8$

Initial Investment $ $2,000\mathrm{.}00$ $ $2,000\mathrm{.}00$ $ $2,000\mathrm{.}00$ $ $2,000\mathrm{.}00$ $ $2,000\mathrm{.}00$ $ $2,000\mathrm{.}00$ $ $2,000\mathrm{.}00$ $ $2,000\mathrm{.}00$

Year

$1$ $ $330\mathrm{.}00$ $ $1,666\mathrm{.}00$ $ $160\mathrm{.}00$ $ $280\mathrm{.}00$ $ $2,200\mathrm{.}00$ $ $1,200\mathrm{.}00$ $ $(350\mathrm{.}00)$

$2$ $ $330\mathrm{.}00$ $ $334\mathrm{.}00$ $ $200\mathrm{.}00$ $ $280\mathrm{.}00$ $ $900\mathrm{.}00$ $ $(60\mathrm{.}00)$

$3$ $ $330\mathrm{.}00$ $ $165\mathrm{.}00$ $ $350\mathrm{.}00$ $ $280\mathrm{.}00$ $ $300\mathrm{.}00$ $ $60\mathrm{.}00$

$4$ $ $330\mathrm{.}00$ $ $395\mathrm{.}00$ $ $280\mathrm{.}00$ $ $90\mathrm{.}00$ $ $350\mathrm{.}00$

$5$ $ $330\mathrm{.}00$ $ $432\mathrm{.}00$ $ $280\mathrm{.}00$ $ $70\mathrm{.}00$ $ $700\mathrm{.}00$

$6$ $ $330\mathrm{.}00$ $ $440\mathrm{.}00$ $ $280\mathrm{.}00$ $ $4,000\mathrm{.}00$ $ $1,200\mathrm{.}00$

$7$ $ $330\mathrm{.}00$ $ $442\mathrm{.}00$ $ $280\mathrm{.}00$ $ $2,250\mathrm{.}00$

$8$ $ $1,000\mathrm{.}00$ $ $444\mathrm{.}00$ $ $280\mathrm{.}00$

$9$ $ $446\mathrm{.}00$ $ $280\mathrm{.}00$ $ $2,000\mathrm{.}00$

$10$ $ $5,000\mathrm{.}00$ $ $448\mathrm{.}00$ $ $280\mathrm{.}00$

$11$ $ $450\mathrm{.}00$ $ $280\mathrm{.}00$

$12$ $ $451\mathrm{.}00$ $ $280\mathrm{.}00$

$13$ $ $451\mathrm{.}00$ $ $280\mathrm{.}00$

$14$ $ $452\mathrm{.}00$ $ $280\mathrm{.}00$

$15$ $ $9,000\mathrm{.}00$ $ $(2,000\mathrm{.}00)$ $ $280\mathrm{.}00$

Sum of cash flow

benefits $ $3,310\mathrm{.}00$ $ $7,165\mathrm{.}00$ $ $9,000\mathrm{.}00$ $ $3,561\mathrm{.}00$ $ $4,200\mathrm{.}00$ $ $6,200\mathrm{.}00$ $ $4,560\mathrm{.}00$ $ $4,150\mathrm{.}00$

Excess of cash flow

Over investment $ $1,310\mathrm{.}00$ $ $5,165\mathrm{.}00$ $ $7,000\mathrm{.}00$ $ $1,562\mathrm{.}00$ $ $2,200\mathrm{.}00$ $ $4,200\mathrm{.}00$ $ $2,560\mathrm{.}00$ $ $2,150\mathrm{.}00$

Yellows$/$italics indicate year in which payback is accomplished