Case Report: The Investment Detective Year
Project 1
Initial investment 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Sum of cash flows benefits Excess of cash flow over initial investment
-2,000
Project 2 -2,000
330 330 330 330 330 330 330* 1,000
Project 3 -2,000
Project 4 -2,000
Project 5 -2,000
Project 6 -2,000
Project 7 -2,000
Project 8
280 280 280 280 280 280 280 280* 280 280 280 280 280 280 280
2,200*
1,200 900* 300 90 70
-350 -60 60 350 700 1,200 2,250*
10,000*
160 200 350 395 432 440* 442 444 446 448 450 451 451 452 -2,000
1,666 334* 165
-2,000
3,310
2,165
10,000
3,561
4,200
2,200
2,560
4,150
1,310
165
8,000
1,561
2,200
200
560
2,150
1. We could blindly rank the projects by simple inspection of the cash flow, which are by looking at the pay back period time and excess of cash flow. Excess of cash flow over initial investment Rank Payback period Rank
Project 1
Project 2
Project 3
Project 4
Project 5
Project 6
Project 7
Project 8
1310
165
8000
1561
2200
200
560
2150
5 7 5
8 2 2
1 15 8
4 6 4
2 8 7
7 1 1
6 2 2
3 7 5
Ranking by looking at the excess of cash flow, the preferable investment would be project 3 and by payback period, the preferable investment would be project 6. However, by using these methods we simply neglecting the time values of money and the companies’ cost of capital. We use capital budgeting tools to measure financial performance of projects. The major available tools are NPV, IRR, PI and others. By using these tools we can conclude whether sum of the cash flows of a project exceeds expected return rate or cost of capital of a company or not. 2. Criteria that might be used to rank the projects are NPV, PI, IRR and MIRR. We were still in doubt which method is the best because the theoretical and practical
strengths of the approaches differ. We would use both NPV and IRR as the best method looking from the theoretical and practical view. One of the reason why we still in doubt which one is the better method because of mutually exclusive between project 7 and 8. For project 7 and 8 that mutually exclusive, the company could have some difficulties deciding depend on the cost of capital and NPV, as in figure below
Project 7&8
$3,000.00 $2,000.00 $1,000.00 $0.00
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% -$1,000.00 -$2,000.00 Project 7
Project 8
The IRR of project 7 is greater than the IRR of project 8, so managers using the IRR method to rank projects will always choose 7 over 8 The NPV of project 7 is sometimes higher and sometimes lower than the NPV of project 8; thus, the NPV method will not consistently rank project 7 above project 8 or vice versa. The NPV ranking will depend on the firm’s cost of capital. When the cost of capital is approximately 10%, projects 7 & 8 have identical NPVs. 3. Ranking by quantitative methods
NPV
Period Table Value 0 1 0.9091 2 0.8264 3 0.7513 4 0.6830 5 0.6209 6 0.5645 7 0.5132 8 0.4665 9 0.4241 10 0.3855 11 0.3505 12 0.3186 13 0.2897 14 0.2633 15 0.2394 Σ PV NPV Rank Profitability Index Rank IRR Rank
Project 1 -2,000.00 300.00 272.73 247.93 225.39 204.90 186.28 169.34 466.51
Project 2 -2,000.00 1,514.55 276.03 123.97
2,073.09 73.09 6 3.65% 6 10.87% 6
1,914.55 -85.45 8 -4.27% 8 6.31% 8
Project 3 -2,000.00
2,393.92 2,393.92 393.92 1 19.70% 1 123.61% 1
Project 4 -2,000.00 145.45 165.29 262.96 269.79 268.24 248.37 226.82 207.13 189.15 172.72 157.72 143.70 130.64 119.03 -478.78 2,228.22 228.22 2 9.21% 2 12.33% 3
Project 5 -2,000.00 254.55 231.40 210.37 191.24 173.86 158.05 143.68 130.62 118.75 107.95 98.14 89.22 81.11 73.73 67.03 2,129.70 129.70 5 6.49% 5 11.12% 5
Project 6 -2,000.00 2,000.00
Project 7 -2,000.00 1,090.91 743.80 225.39 61.47 43.46
Project 8 -2,000.00 -318.18 -49.59 45.08 239.05 434.64 677.37 1,154.61
2,000.00 7 0.00% 7 10.00% 7
2,165.04 165.04 4 8.25% 3 15.26% 2
2,182.98 182.98 3 7.73% 4 11.41% 4
The rank using quantitative methods differ from the ranking by simple inspection of cash flow. This is happened because the ranking using quantitative methods take value of money and discount rate into account. By using quantitative methods, we recommend the company to invest on project 3, 4, 7 and 8. 4. Real investment projects that have similar cash flow: Project 1 Leasing or Partially Amortizing Bond Project 2 Advertising campaign Project 3 Zero-Coupon Bond Project 4 Nuclear-power plant Project 5 Leasing with 0 terminal value or Home mortgage Project 6 One-year bond Project 7 Mine Project 8 Orchard
