CASE STUDY

The Investment Detective The essence of capital budgeting and resource allocation is a search for good investments in which to place the firms capital. The process can be simple when viewed in purely mechanical terms, but a number of subtle issues can obscure the best investment choices. The capital budgeting analyst is necessarily, therefore, a detective who must winnow good evidence from bad. Much of the challenges is knowing what quantitative analysis to generate in the first place. Supposed you are a new capital budgeting analyst for a company considering investments in the eight projects listed in Exhibit 1. The chief financial officer of your company has asked you to rank the projects and recommend the four best that the company should accept.

Part I For the first part of this assignment only quantitative considerations are relevant. No other project characteristics are deciding factors in the selection, except that management has determined that projects 7 and 8 are mutually exclusive. All projects require the same initial investment, $2,000,000. Moreover, all are believed to be of the same risk class. The weighted average cost of capital for the first part is 10%. To simulate your analysis, consider the following questions: 1. Can you rank the projects simply by inspecting the cash flows? The projects cant be ranked just simply by inspecting the cash flows. In order to rank the projects we must bring all cash flows to the same point in time (present) before we can even compare. This must be done first because of time value of money. If a dollar is received now it is more valuable than a dollar that would be received sometime in the near future. In saying that the cash flows must be brought to present before we can even start to rank the projects. 2. What criteria might you use to rank the projects? Which quantitative ranking methods are better? Why? Looking at the projects there are several criteria that can be used to rank the projects, such as using the projects IRR, Payback period and NPV. NPV results in the best ranking because IRR only works if there is a series of cash flows that shows results in an initial outlay followed by future inlay. Any sequence of cash flows that does not support this, will not yield accurate results with the IRR method. Also, IRR just gives a percentage,

which will ignore the magnitude of cash flows. Payback period plainly ignores the time value of money, which is considered to be a major flaw of this methodology. All of the drawbacks of IRR and Payback period, NPV is usually the best method for capital budgeting. 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? The rankings that I found by using the quantitative methods is as followed: Projects ranked by using NPV methods (see the attach excel file) 1) Project 6 2) Project 2 3) Project 7 4) Project 4

Projects ranked by using IRR method (see the attach excel file) 1) Project 6 2) Project 2 3) Project 7 4) Project 4

Projects ranked by using Payback Method (see the attach excel file) 1) Project 6 2) Project 2 3) Project 7 4) Project 4

Yes this ranking does differ from the ranking that is obtained by simple inspection of the cash flows (see the attach excel file) Projects are ranked as followed 1) Project 3 2) Project 2 3) Project 6 4) Project 7

4. What kinds of real investment projects have cash flows similar to those in the exhibit? Project 1 is mostly similar to the investment in a coupon bond, where you are able to get coupon payments periodically at the end of the period when you get the principal. Project 2 and 6 are most likely like the actual venture capital project where bulks of cash inflows occurs at the end while some of the cash inflows takes place at the beginning. Project 3 is related to the zero coupon bond where you can purchase the bond at a specific price and you receive an big cash outflow at the end of the maturity period. The following Projects 4,7 and 8 are closely similar to an investment in a machinery, which generates positive cash for you for a certain period of time. After awhile, you can sell that off and receive some more cash. There might be some additional cash outflows initially to get the machinery going. Project 5 is similar to annuity.

Part II The company has the following capital structure: Account Long-term Debt Preferred Stock Common Stock $ 2,000,000 500,000 2,500,000 Costs before tax 10% 14% 18%

1. Calculate the weighted average cost of capital (tax is 36%) Weighted average cost of capital = (2M/5M) x10 x (1-.36) + (.5 M/5M) x 14 + (2.5 M/5M) x 16 WACC = 11.96% 2. Using the same cash flows in exhibit I find the NPV, PI, IRR and MIRR. Which project(s) would you recommend and why? My decision still remains the same as above, I am still choosing NPV and select the following for the same reasons as stated as above because NPV is typically considered to be the best metric method for evaluating projects: 1) Project 6 2) Project 2 3) Project 7 4) Project 4

Part III Based on the following information prepare Performa income statement. Using the data, calculate the DOL, DFL and DTL, earring per share. Q = 20, 000 units Price = $120 VC= $80 Fixed cost = $400,000 100,000 outstanding shares