This case presents the cash flows of eight unidentified investments, all of equal initial investment size. The student’s task is to rank the projects. The first objective of the case is to examine critically the principal capital-budgeting criteria. A second objective is to consider the problem that arises when net present value (NPV) and internal rate of return (IRR) disagree as to the ranking of two mutually exclusive projects. Finally, the case is a vehicle for introducing the problem created by attempting to rank projects of unequal life and the solution to that difficulty criterion.
Please answer following questions
1. What analytical criteria can we use to rank the projects? How do you define each criterion? Please evaluate each project using all investment criteria we learned during the class. 2. Which of the two projects, 7 or 8, is more attractive? How sensitive is our ranking to the use of high discount rates? Why do NPV and IRR disagree? 3. What rank should we assign to each project? Why do payback and NPV not agree completely? Which criterion is best? 4. Are those projects comparable on the basis of NPV? Because the projects have different lives, are we really measuring the “net present” value of the short-lived projects?
(Question 4 Hint)
Comparisons based on standard NPV ignore the inequality of project lives such as those in the case. Simply put, short-lived projects could be replicated within the life of the longest project (for example, project 6 could be replicated 15 times within the life of project 3), producing very different time profiles of cash flows for the projects. One solution to this problem is the so-called replacement-chain approach, in which shortlived projects are replicated out to a horizon common with the long-lived projects; the NPV on the entire chain is then calculated and compared with the NPV of the other chain. This approach can be cumbersome, however, in problems with many alternative...