(Capital Budgeting: Ranking Problems)
OBJECTIVE:The objective of this case is to explore the ranking differences that may result from using the PI, NPV, and IRR evaluation techniques. It illustrates the time disparity, size disparity, and life disparity problems and the appropriate approaches to the resolution of these problems. This case works well either as a homework problem coinciding with the introduction of project ranking and capital-rationing material or as an in-class problem lecture. DEGREE OF DIFFICULTY: Moderately Difficult
Although all methods might grant projects acceptable ratings, NPV, PI, and IRR will not necessarily yield the same ranking order. Such a phenomenon is the result of different cash inflows over time (projects A and B), time horizons (projects E and F) and/or project sizes (projects C and D). No. While, in general, it is true that when one discounted cash flow method (NPV, PI, or IRR) gives a project an acceptable rating, the other two methods also give this project an acceptable rating; it is not necessarily true that these discounted cash flow methods will rank these acceptable projects in the same order. Ranking differences may occur as a result of (a) the time disparity problem resulting from differences in the cash inflow patterns over time between two projects; (b) the size disparity problem, resulting from the comparison of projects requiring initial cash outflows of differing size; or (c) the life disparity problem, resulting from projects with differing lives. These problems are illustrated in the case with Projects A and B representing the time disparity problem, C and D, the size disparity problem, and with E, F, G, and H, the life disparity problem. The ranking problems incurred using the discounted cash flow methods are generally a function of the different assumptions made about the reinvestment opportunities for cash inflows over the life of the project. 2. Project...