The Investment Detective

Project Free Cash Flows (dollars in thousands)

Project number: 1 2 3 4 5 6 7 8

Initial investment (2,000) (2,000) (2,000) (2,000) (2,000) (2,000) (2,000) (2,000)

Year

1 $ 330 $ 1,666 $ 160 $ 280 $ 2,200 $ 1,200 $ (350)

2 330 334 200 280 900 (60)

3 330 165 350 280 300 60

4 330 395 280 90 350

5 330 432 280 70 700

6 330 440 280 1,200

7 330 442 280 2,250

8 1,000 444 280

9 446 280

10 448 280

11 450 280

12 451 280

13 451 280

14 452 280

15 10,000 (2,000) 280

Sum of Cash Flow Benefits $ 3,310 $ 2,165 $ 10,000 $ 3,561 $ 4,200 $ 2,200 $ 2,560 $ 4,150

Excess of Cash Flow over initial investment $ 1,310 $ 165 $ 8,000 $ 1,561 $ 2,200 $ 200 $ 560 $ 2,150

Indicates year in which payback is accomplished

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 Exhibit 1?

1. Although we can rank the projects by simply inspecting the cash flows, it is still not a good measure to rank them.

The Ranking by simply inspecting the cash flows:

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th

Project 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

2. It would be better and more accurate if we used quantitative methods like Net Present Value, Payback Period, Discounted Payback Period, Internal Rate of Return, Average Accounting Return, or Profitability Index.

a. Net Present Value:

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th

Project 3 4 8 7 5 1 6 2

NPV 393.92 228.22 182.98 165.04 129.70 73.09 0.00 -85.45

b. Payback Period:

Project 1:

Year’s cumulative

0 -2000

1 -1670

2 -1340

3 -1010

4 -680

5 -350

6 -20

7 310

Payback period = 6 + 20/330 = 6.06 years

Project 2:

Year’s cumulative

0 -2000

1 -334

2 0

3

Payback period = 2 years

Project 3:

Payback