The Investment Detective

1) Without taking into account the time value of money, the projects ranked according to the cash flow are as follows:

3 , 5 , 8 , 4 , 1 , 7 , 6 , 2

Based strictly on cash flow, the project that can generate the most excess cash over initial investments will be ranked first.

2) Criteria used are the no. of years that the investment amount was recovered and the discount rate.

There are several evaluation methods:

Accounting Rate of Return

A project is considered acceptable if it is expected to produce an average profit relative to the level of investment at a rate at least equal to the firm’s desired return on investment.

ARR = Average Profit / Initial Investment

Payback Method

Measure of the expected time before the initial investment will be recovered. Accept the project if payback is faster than the targeted payback. This method ignores the time value of the cash flows and their riskiness.

Internal Rate of Return

An investment project will be acceptable if IRR is greater than or equal to the required rate of return for that project. The higher the IRR, the better.

Present Value Index

Known as “profitability index”. PVI was introduced for the purpose of ranking investment alternatives in the sense that it provides an indication of which alternative produces the highest return relative to the size of the investment. The highest PVI will be chosen.

PVI = PV of Inflows / PV of Outflows

Net Present Value

NPV greater than or equal to zero indicates an acceptable project that at least earns the firm’s required rate of return. For ranking projects, the project with the highest NPV is preferred since it has the highest value.

The 2 highlighted methods are better measures. They take into account the time value of money as well as the riskiness.

3) NPV Method & IRR Method

n CFt

NPV = пЃ“ ------------

t = 0 (1 + r)t

n CFt

IRR: 0 = пЃ“ --------------

t = 0 (1 + IRR)t

Refer to excel worksheet for detailed calculations.

Both NPV and IRR give the same results.

Project 3 is preferred, as it has a higher NPV value (maximise shareholders’ wealth).

Rank by Cash Flow = 3, 5, 8, 4, 1, 7, 6, 2

Rank by NPV & IRR = 3, 4, 8, 7, 5, 1, 6, 2

4) It could be one-time construction project.

c) IRR Method

n CFt

0 = пЃ“ --------------

t = 0 (1 + IRR)t

Investment A

10,000 25,000 25,000 380,000

0 = - 170,000 + -------------- + --------------- + ---------------- + -----------------

(1 + IRR) (1 + IRR)2 (1 + IRR)3 (1 + IRR)4

IRR = 29.34%

Investment B

10,000 6,000 10,000 8,000

0 = - 18,000 + -------------- + --------------- + ---------------- + -----------------

(1 + IRR) (1 + IRR)2 (1 + IRR)3 (1 + IRR)4

IRR = 32.01%

Choose Investment B, as it gives a higher internal rate of return.

d) Profitability Index

Present Value of Inflows

PVI