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Case 17 – The Investment Detective The case of the Investment Detective laid out the cash flows for us in each of eight different projects. Before doing any calculations we came up with the assumption that we could not rank the projects simply by inspecting the cash flows. Without the ability to rank the projects based off of cash flows solely, we had to use some analytical criteria as a capital budgeting analyst to provide some thorough support and reasoning for how we ranked the four best projects.In this case we are only using quantitative considerations that we deem to be relevant and no other project characteristics are deciding factors in our selection of the best four projects.
When coming up with our calculations to rank the four best projects we have to take into account that each project is going to require an initial investment of two million dollars and in using historical data from other capital budgeting analysts in the firm, we deemed a ten percent discount rate as an appropriate figure for our calculations.The analytical criteria in which we feel we gives us the best results to help us choose the top four projects are Net Present Value, Internal Rate of Return, and the Payback Period calculation. We are basing our rankings solely on the results we receive from our Net Present Value calculations because we feel this method to be the most consistent and it also takes into account all of the cash flows as well as the time value of money. If a positive Net Present Value calculation is received than that means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.With each project we are looking to maximize owner wealth and with the Net Present Value technique, the calculation is a direct measure of how well each individual project will meet the goal of maximizing owner wealth. Although Net Present Value is our primary decision making criterion, the most important alternative to Net Present Value is the Internal Rate of Return calculation. The Internal Rate of Return is based entirely on the estimated cash flows and is independent of interest rates that may rise and fall with the times.
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The Internal Rate of Return methodology is very important to capital budgeting analysts to the point to here some analysts get a better feel for the percentage returns and the value that is created when using the Internal Rate of Return method as opposed to seeing dollar value increases in the Net Present Value method. In comparing Projects 7 and 8, which are mutually exclusive projects, we came up with the decision that Project 7 will be the more attractive investment to move forward with. With projects 7 and 8 being mutually exclusive we were only able to pick one even if project 8 may have been more attractive than six of the other projects that we were also researching.When we were doing the calculations for Projects 7 and 8 we experimented with the sensitivity of discount rates and decided to see how the numbers would be affected as the discount rates rose. With both projects we saw right off the back that the projects were very sensitive to rising discount rates. Each project started off with a positive Net Present Value at a ten percent discount rate but as the discount rate rose just five percent we immediately noticed an adverse adjustment in the Net Present Value of the projects.
As the discount rate rose even higher we continued to see the negative Net Present Value figures rise even higher which showed how sensitive the figures were to high discount rates. In working with a mutually exclusive project we find that the Net Present Value and Internal Rate of Return disagree solely because the time value of cash flows are substantially different. Net Present Value and Internal Rate of Return can disagree when the initial investments are substantially different as well but in this case the initial investment was the same.In fully investigating all of our calculations we are fully invested in using the Net Present Value figures we calculated as a means of ranking the eight projects.
In doing so we found reasons in which why the Net Present Value was our benchmark for ranking the projects and why we did not use the Payback Method. The Payback Method ignores the time value of money, requires and arbitrary cutoff point, ignores cash flows beyond the cutoff date, and is biased against long-term projects, such as research and development and new projects.When comparing the Average Accounting Return Method to the Net Present Value method we found that the Average Accounting Return Method is a worse option than using the Payback Method. The Average Accounting Return Method is not a true rate of return and the time value of money is ignored, it uses an arbitrary benchmark cutoff rate, and is based on accounting net income and book values, not cash flows and market values.
Plain and simply put, the Net Present Value method is the best criterion to use when ranking these eight projects.