Vav

1. Can you rank the projects simply by inspecting the cash flows?

Analyzing the sum and the excess of cash flow can give the business an

order of the most profitable investments; however it does not give the

full details that are important to determining true profitability. As

one can see from the charts, Project Number 3 has the highest sum of

cash-flow benefits and excess of cash flow, but the payback is not

accomplished until the 15th year. Other Projects may not have a high

sum of cash-flow; however the initial payback happens very quickly which

proves to be important when making these types of investments. The Net

Present Value can not be figured from just inspecting the cash flows nor

can any of the other procedures necessary to fully get the scope of the

investment. It is important when making investments of this magnitude

to evaluate all procedures available to decide upon the best one.

2. What criteria might you use to rank the projects? Which quantitative

ranking methods are better? Why?

Several different procedures are available to analyze potential business

investments. Some concepts are better than others when it comes to

reliability but all provide enough information to get the general scope

of the investment. The five procedures that provide useful information

are the Net present Value (NPV), the Payback Rule, the Average

Accounting Return (AAR), the Internal Rate of Return (IRR), and the

Profitability Index (PI). These procedures will help rank the projects

from the greatest investment to the worst.

First, the most important concept of evaluating these investments is the

NPV. NPV is defined as the difference between an investment's market

value and its cost. It is only a good investment if it makes money for

the company so a positive NPV will be needed. The projects can be

ranked from the most positive NPV to the lowest to determine

profitability. This quantitative ranking method is the best to use due

to its consideration of the time value of money and its more accurate

breakdown of value.

Second, the payback rule is how long it takes to recover the initial

investment. It is noted on the case study as to which year the

investment is recouped and it is easy to rank the projects, however this

is not the best procedure to use. This rule does not involve

discounting which means that time value of money is disregarded, it

fails to consider risk differences, and an accurate cutoff period cannot

be picked.

Third, another possible approach is the AAR. This is defined as an

investment's average net income divided by its average book value.

The projects can be ranked according to the excess of AAR compared to

the target AAR. Once again, this is a flawed approach because it is not

comparable to the returns offered, it ignores time value, it does not

have an objective cutoff period, and it does not use the right factors

to determine the effects on share price from taking on an investment.

It may be easy to compute but overall does not provide valuable

investment information.

Fourth, the IRR is the next closest alternative to the NPV calculations;

therefore it