Drawback of non-discounted cash flow does not consider TVM and the rate of return, and the discounted cash flow does not examine all the cash flows.

The investment Detective

Answer Q1:

We can rank the projects by simply inspecting the cash flows (mention bellow), yet it’s not a good measure to rank them.

We can’t rank the projects by only simple inspection of the cash flows because of the time value of money and cost of capital of companies. We use capital budgeting tools to measure financial performance of projects.

The Ranking by simply inspecting the cash flows:

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Projects 3 5 8 4 1 7 6 2
Cash Flows $10,000 $4,200 $4,150 $3,561 $3,310 $2,560 $2,200 $2,165

Answer Q2:

In order to rank these projects, in a purely quantitative manner, we used the following for the 8 projects:

  1. Net Present Value (NPV)
  2. Internal Rate of Return (IRR)
  3. Payback Period (PP)
  4. Profitability Index (PI)

 

  1. Net Present Value (NPV)
Year Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Project 7 Project 8
0 ($2,000) ($2,000) ($2,000) ($2,000) ($2,000) ($2,000) ($2,000) ($2,000)
1 300.00 1,514.55 145.45 254.55 2,000.00 1,090.91 (318.18 )
2 272.73 276.03 165.29 231.40 743.80 (49.59)
3 247.93 123.97 262.96 210.37 225.39 45.08
4 225.39 269.79 191.24 61.47 239.05
5 204.90 268.24 173.86 43.46 434.64
6 186.28 248.37 158.05 677.37
7 169.34 226.82 143.68 1,154.61
8 466.51 207.13 130.62
9 189.15 118.75
10 172.72 107.95
11 157.72 98.14
12 143.70 89.22
13 130.64 81.11
14 119.03 73.73
15 67.03
S PV(CF) 2,073.086 1,914.545 2,393.920 2,228.222 2,129.702 2,000 2,165.041 2,182.984
NPV 73.086 (85.455) 393.920 228.222 129.702 0 165.041 182.984
Rank 6th 8th 1st 2nd 5th 7th 4th 3rd
  1. Internal Rate of Return (IRR)

 

Projects Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Project 7 Project 8
IRR 10.87% 6.31% 11.33% 12.33% 11.12% 10.00% 15.26% 11.41%
Rank 6th 8th 4th 2nd 5th 7th 1st 3rd

 

All of these projects are accepted except Project 2 because its cost of capital has higher percentage than the percentage project internal rate of return. Moreover, Project 6 will be a subject of be in different because the cost of capital equal to internal rate of return, which lead to break even project.

  1. Payback Period (PP)

In Payback Period there are two method, non-discounted cash flow and discounted cash flow. Drawback of non-discounted cash flow does not consider TVM and the rate of return, and the discounted cash flow does not examine all the cash flows.

Projects Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Project 7 Project 8
Payback Year 7 2 15 6 8 1 2 7
Payback 2,310 2,000 10,000 1,977 2,240 2,200 2,100 4,150
Discounted Payback 1,606.58 1,790.58 2,393.92 1,360.10 1,493.78 2,000 1,834.71 2,182.98
Decision (DPP) Reject Reject Accept Reject Reject Be in different Reject Accept
Rank 6th 5th 1st 8th 7th 3rd 4th 2nd

 

 

  1. Profitability Index (PI)
Projects Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Project 7 Project 8
PI  1.037 0.957 1.197 1.092 1.065 1.000 1.083 1.0773
Rank 6th 8th 1st 2nd 5th 7th 3rd 4th

 

All the projects will be undertaken except for project 8 since it is mutually exclusive with project 7, and project 6 and 2 will not be undertaken since they have IRR that is less than the 10%, the discount rate. Project 1 also might not be taken since “certain officers of the company have recently asserted that the discount rate should be much higher.”

Rank 1st 2nd
Project 8 7
IRR 11.41% 15.26%
NPV 182.98 165.04

Since these two projects are mutually exclusive and have the IRR above 10%, Project 8 will be chosen because it has higher NPV.

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 3 4 8 7 5 1 6 2
PI 1.197 1.092 1.083 1.0773 1.065 1.037 1.000 0.957

All the projects will be undertaken except for project 7 since it is mutually exclusive with project 8, and project 6 and 2 will not be undertaken since they have PI’s equal to 1 and 0.957, because they are not greater than 1.

Selected Projects as per the quantitative methods as follow:

Rank 1st 2nd 3rd 4th
Projects Projects 3 Projects 4 Projects 8 Projects 5

 

  •  Comparing the quantitative methods, we noticed that project 3 scored 1st four times using simple inspections of cash flows, NPV, PP, and PI. Project 7 however, scored 1st only through using the IRR method. Looking on the last ranked projects, project 2 has scored last 4 times using simple inspections of cash flows, NPV, IRR, and PI.
  •  Net Present Value is considered the best approach since it:
  1.  Uses Cash Flows.
  2.  Uses all the Cash Flows of the project.

iii.    And discounts the Cash Flows properly.

And through using the NPV approach, Project 3 got the highest NPV, 393.92, and then comes 4, 8, 5 and 1.

Answer 3:

Selected Projects as per the quantitative methods as follow:

Rank 1st 2nd 3rd 4th
Projects Projects 3 Projects 4 Projects 8 Projects 5

 

The above table showing that it is absolutely the rank will be differ from the ranking obtain by simple inception of the cash flow

Answer 4:

Project 1    Bonds

Project 2    Equipment Depreciation

Project 3    Land or real assets investments

Project 4    Diary factory that incur agricultural costs

Project 5    Car Loan

Project 6    Stock

Project 7   Trucks Depreciation

Project 8   Construction projects

 

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