Question

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).

Answer 1

There are various methods to rank a project upon which includes NET PRESENT VALUE, INTERNAL RATE OF RETURN, PROFITABILITY INDEX.

Please refer the workings below for the ranking of the best four projects to be selected by the company.

Alignment Clipboard Number Styles Font Cells 129 M. A C D G N 1 Project Number 2 Initial Investment 8 (2,000) S 1,200 $ 10 15 1 2 3 A 5 6 7 (2,000) S 330 $ (2,000) S 1,666 S 334 $ (2,000) S 160 S (2,000) $ PVF (2,000) S (2,000) S 2.200 S (2,000) PVF 1 280 (350) 0.9091 0.8696 3 200 S 280 S 330 900 (60) 0.8264 0.7561 330 $ 165 S S 350 S 280 $ 280 $ 280 S 280 S 5 300 60 0.7513 0.6575 395 $ 432 $ 440 $ 6 330 90 350 0.6830 0.5718 330 S 330 S 7 70 700 0.6209 0.4972 - 0.4323 1,200 2,250 0.5645 - 0.3759 330 S 280 S 0.5132 442 1,000 446 $ 448 $ 450 S 451 S 451 S 452 S 280 S 0.2843 04241 17 S 280 S 280 $ 280 S 280 S 280 S 280 S 4.200 S S 0.3855 0.2472 10 13 S 11 0.3505 0.2149 - 14 S 12 0.3186 0.1869 - - . 15 S 13 0.2897 0.1625 - - 16 S 14 0.2633 0.1413 - - 10,000 $ 10.000 S (2,000) S 3,561 S 0.1229 17 15 0.2394 3.310 S 2,165 $ 2,560 S 2.200 S 4.150 18 Sum of Cash Flow Benefits Excess of Cash Flow over 19 Initial Investment 165 S 8,000 S 1,561 $ S 200 S 560 S 1,310 S 2,200 2,150 20 NPV Present Value of Cash Inflow Present Value of Cash Outflow 182.98 (85.45)5 (190.26S 228.22 S 129.70 S (362.74) $ 393.92 $ (771.06) $ 11.69 21 Calculation of NPV at 10% 165,04 S 73.09 (300.16) S (86.96) S 22 Calculation of NPV at 15% (227.42 7.52 (397.48) 12.50 15.24 10.00 23 IRR 10.98 5.92 11.32 11.58 [Lower Rate Lower Rate NPV)(Difference in Rates)}/(Lower Rate NPV-Higher Rate NPV) Proposal Acceptance, if 25 IRR NPV, Otherwise Reject 24 Reject Indifferent Accept Accept Accept Accept Accept Accept Third First Since project 7 and 8 are Fourth 26 Second 27 Ranking on basis of IRR mutually exclusive First First Third Third First Third 28 Second Fourth 29 Ranking on basis of NPV First Second Third Fourth 30

For calculations related to Present Value Factor and NPV, please the screenshot of formulas used.For calculation of IRR, please refer the screenshot below for formulas used

fable styles Formatting Select Font Clipboard Alignment Number Styles Editing els f(B$3 $L$3+B$4 $L$4+B$5*$L$5+B$6*$L$6+B$7*$L$7+B$8*$L$8+B$9*$L$9+B$10*$L$10+B$11*$L$11+B$12 $L$12+B$13 *$L$13 +B$14*$L$14+B$15*$L$15+B$16*$L$16+B$17*$L$17)+ B$2 B21 H I J 10 B A C G N 1 Project Number Initial Investment 1 4 5 15 -2000 -2000 -2000 -2000 -2000 -2000 -2000 -2000 PVF PVF 2200 1666 1200 //1-SMS1/10oe44 -1/11-SM$1 / 100) A5 5 3 T-1/(1+SLS1/100) A5 300 165 350 280 -1/(1-SLS1/100) A6 6 4 395 50 33 28L 90 a/eaMSi/100) A5 VCIS1/100-A8 -1/11 SM$1/100) A8 - 1 / ( 1 - $M$ 1 / 100) A9 440 8 280 120 -1/(1+SLS1/100) AS 2250 9 7 447 280 1000 tLE1/1001241 T-1/(1 SLS1/100) A12-1/ 1 1+ SM$1/100)^A12 e1/+SL51720 MS1/10014414 -01SMS1/1001 411 11 9 AME 290 12 10 448 280 14 11 280 -1/(1+SLS1/100) A15-1 / 1 1 - SMS1/100) A15 T-1/11 SLS1/100) A161-1/11. SM$1/100) A16 1/(1+SL$1/100)A17-1/( 1 + SM$1 / 100) A17 15 13 451 28C 16 14 452 284 0000 SUM(B3:B17)-SUMIC3:C17 )-SUM D3:D17 ) -SUM(E3:E17 ) -SUM(F3:F17 )ESUM(G3:G17) ESUMH3 :H17) -SUM(I3:117) 18 Sum of Cash Flow Benefits Cash Flow over Initial F18 F2 -H18+ H2 19 -G18+G2 -18+12 -818+B2 C18+C2 -D18+ D2 -E18+E2 NPV-Present Value of Cash inflow- Present Value of Cosh Outfiow 20 21 Calculation of NPV at 10 % -(BS3 SL53+ B54-(CS3 SLS3+C- ( DS3 SLS3 DS4- ( ES 3 SLS3 ES-(FS3 SLS3 FS-(G53 SLS3 GS-(HS3 . SLS3+HS- ( I53 . SLS3 +1S $3 SMS3 d-(DS3 SMS3+D -(BS3 . SMS3+85 (ES3 SM$3 E-(F$3 SMS3+FS- (GS3 $M$3 GS-(H$3 SMS3 + H -(IS3 SMS3+1 Calculation of NPV at 15% ( SL$1+ ( ( B21 ) -(SL$1+( ( C21 ) 1 -(SL$1+ ( ( D21 ) -(SL$1+( ( E21 ) 1 -(SL$1+( F21 ) 1 -(SL$1+ ( (G21 ) ( -(SL$1+( (H21 ) |-(SL$1+ ( ( 121 ) 1 23 IRR = [Lower Rate+((Lower Rate NPV)"(Derence in Haces rRate 24

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Styles Clipboard Font Alignment Cells Editing Number f(SL$1+( ( B21 )*($M$1-$L$1))/(B21-B22)) B23 J 10 M B C D P H 1 Project Number T15 1 2. 3 4 5 6 nitial Investment -2000 -2000 00 -1/(1+ SL$1 / 100)ASA3 -1/(1+SL$1 / 100 ) A4 1200 -1/ ( 1+ SM$1/100)^A3 -1/ ( 1 + SM$1/100) A4 330 Cce 160 2200 260 334 60 4 2 5 3 6 4 330 200 900 0 280 0 1/ (1+SM$1 / 100)^A5 - 1 / ( 1+ $M$1/100) A6 330 165 350 280 300 60 1/(1+SLS1 / 100) A5 1/(1+SLS1/100) A6 90 330 395 280 350 =1//1+SL51/100) A8 =1/ ( 1+SMS1/ 1001 A8 8 6 330 130 440 9 7 2250 330 0 442 280 -1/(1+SLS1/100) A9 1/(1 SLS1/100) A10 =1/(1+SLS1/100)^A11 -1/ ( 1 + $M$1/100)^A9 -1/ ( 1- SMS1/100) A10 1/ ( 1+ SM$1 / 100) A11 0 10 8 1000 0 444 280 0 0 11 9 0 446 280 0 0 -1/(1 SL$1/100)A13 1/ (1+SLS1 / 100 ) A14 -1/(1-SM$1 /100) A13 -1/ ( 1 + SMS1/100) A14 -1/ ( 1+ SM$ 1 / 100) A15 -1/(1 SMS1/100) A16 - 1 / ( 1+ SMS1/100) A17 13 11 450 280 0 14 12 0 C 451 280 0 15 13 0 451 280 1/(1+SLS1/100)^A15 1/(1+SL51/100) A16 1/ ( 1+SLS1 / 100)^A17 45 16 14 280 10000 SUM(C3:C17)-SUM(D3:D17 ) SUM(E3:E17)-SUM(F3:F17 ) -SUM(G3:G17) -SUM(H3:H17 ) -SUM (13:117) 18 Sum of Cash Flow Benefits SUM(B3:B17) Excess of Cash Flow over Initial - E18 + E2 - C18+ C2 -D18 + D2 - F18 + F2 -H18+ H2 -118+12 19 Investment B18+B2 -G18+G2 NPV Present Value of Cash Inflow Present Value of Cash Outflow 20 E( BS3 . SLS3 + BS4 S-(CS3 SLS3+CS-( DS3 . SLS3+ DS4 - ( ES3 . SLS3 +ES- ( FS3 . SLS3+FS4= (GS3 . SLS3 +GS4- ( HS3 . SLS 3+HS - ( IS3 . SLS3+IS 21 Calculation of NPV at 10 % # ( BS3 . SMS3 + B54 - ( C$3 . SM$3+0- ( D$3 . SM$ 3+DS - ( ES3 . SM$3+E- ( FS3 SM$ 3+F- (GS3 . SMS3+GS= ( H$3 . SM$3+H= ( IS3 . SM$3+ SLS1+ ( 821 )(SM-(SLS1+ ((C21)-(SLS1+ID21) *- ( SLS1+((E21) -( SLS1+((F21) . - 1 SLS1+((G21) -(SLS1+ ( (H21 ) -ISL$1+ ( ( 121 ) 22 Calculation of NPV at 15% 23 IRR [Lower Rate ((Lower Rate 24 NPV)(Difference in Rates))/(Lower Rate Proposal Acceptance, if IRR>NPv 을유882음원.