The Investment Detective

The essence of capital budgeting and resource allocation is a search for good investments in which to invest 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.

Suppose that 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 $(50\%)$

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 shown in Exhibit I? $(5\%)$

$2.$ What criteria might you use to rank the projects? Which quantitative ranking methods are better? Why? $(15\%)$

$3.$ What is the ranking you found by using quantitative methods $($please show all your calculations$)?(20\%)$ Does this ranking differ from the ranking obtained by a simple inspection of the cash flows? $(5\%)$

$4.$ What kinds of real investment projects have cash flows similar to those in the exhibit? $(5\%)$