The Investment Detective

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Project Free Cash Flows (dollars in thousands)

Project number:12345678
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:
Rank1st2nd3rd4th5th6th7th8th
Project35841762
Cash Flows10,0004,2004,1503,5613,3102,5602,2002,165

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:

Rank1st2nd3rd4th5th6th7th8th
Project34875162
NPV393.92228.22182.98165.04129.7073.090.00-85.45

b.Payback Period:

Project 1:
Year’scumulative
0-2000
1-1670
2-1340
3-1010
4-680
5-350
6-20
7310

Payback period = 6 + 20/330 = 6.06 years

Project 2:
Year’scumulative
0-2000
1-334
20
3

Payback period = 2 years

Project 3:
Payback period = 15 years
Project 4:
Year’scumulative
0-2000
1-1840
2-1640
3-1290
4-895
5-463
6-23
7419

Payback period = 6 + 23/442 = 6.05 years

Project 5:
Yearscumulative
0-2000
1-1720
2-1440
3-1160
4-880
5-600
6-320
7-40
8240

Payback period = 7 + 40/280= 7.14 years

Project 6:
Yearscumulative
0-2000
1200
Payback period = 0.91 years
Project 7:
Yearscumulative
0-2000
1-800
2100

Payback period = 1+ 800/900= 1.88 years

Project 8:
Yearscumulative
0-2000
1-2350
2-2410
3-2350
4-2000
5-1300
6-100
72150

Payback period = 6+ 100/ 2250= 6.04 years

Rank1st2nd3rd4th5th6th7th8th
Project67284153
Payback Period0.911.882.006.046.056.067.1415

c.Discounted Payback Period:

Project 1:
Year’s PV of CF cumulative
0-2000-2000
1330/(1.10)=300-1700
2330/(1.10)^2=272.7-1427.3
3330/(1.10)^3=247.93-1179.37
4330/(1.10)^4= 225.3-954.07
5330/(1.10)^5=204.90-749.17
6330/(1.10)^6= 186.2-562.9
7330/(1.10)^7= 169.34-393.46
81000/(1.10)^8=466.5073.04

Discounted payback period = 7+ 393.46/466.50= 7.84 years...
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