SYNDICATE

Beatrice Fortunata B. Suwarlim

Yohan
M. Gilang Prakasa

14/ YP 54A
29115582
29115641
29115651

Case 5: The Investmen Detective

Background
The essence of capital budgeting and resource allocation is search for good investments in
which place to place the firms capital. The capital budgeting analyst, therefore, is necessarily
a detective who must winnow bad evidence from good. Much of challenge is in knowing
what quantitative analysis to generate in the first place.
We are new capital budgeting analysts. Chief Financial Officer of our company has assigned
us to rank the projects and recommended the four best that the company should accept. In this
assignment, only the quantitative considerations are relevant. The management has
determined that projects 7 and 8 are mutually exclusive. All the projects require the same
initian invenstment, $2 million. All are believed to be the same risk class. The firms
weighted average cost of capital has never been estimated. In the past, analysts have simply
assumed that 10 percent was an appropriate discount rate.
Issue
Ranking the projects and recommended the four best projects that company should accept.
Analysis
There are eight projects should be ranked. All projects require same initial investment, $2
million. All are believed to be same risk class. Analysts had simply assumed that 10 percent
was approriate discount rate. Project 7 and 8 are mutually exclusive.

1. Can you rank the project simply by inspecting the cash flow ?
We could rank the projects by analyzed the the sum of cast flow benefits and excess of cash
flow over initial investment. However, it doesnt give the full details to determine
profitability. As we can see from he Exhibit 1, Project 3 has the highest sum of cash flow
benefits and excess of cash flow over initial investment, but it has the longest payback period,
which is until 15 years. Other projects may not have high sum of cash flow and excess of
cash flow, but they have shorter payback periods. Also, we need to discount back the projects
cash flow. This is a must because of time value of money. Therefore, we cannot rank the
projects simply by inspecting cash flow.
2. What criteria might you use to rank the projects? Which quantitative ranking methods
are better? Why?
There are several quantitative ranking methods, like payback period, profitability index (PI),
net present value (NPV), and internal rate of return (IRR). Payback period, PI, NPV, and IRR
are used to make accept-reject decisions. The payback period decision criteria are: if the
payback period is less than maximum acceptable payback period, accept the project; if the
payback period is greater than the maximum acceptable payback period, reject the project.
Using the PI, the decision rule they follow is to invest in the project when the index is greater
than 1. NPV decision criteria are if the NPV is greater that $0, accept the project; if the NPV
is less than $0, reject the project. IRR decision criteria are if the IRR is greater than the cost
of capital, accept the project; if the IRR is less than the cost of capital, reject the project.
Payback period has major weeakness, which is that the appropriate payback period is merely
a subjectively determined number. It cannot be specified in light of the wealth maximization
goal because it is not based on discounting cash flows to determine whether they add to the
firms value. Instead, the appropriate payback period is simply the maximum acceptable
period of time over which management decides that a projects cash flows must break even.
Many companies use both the NPV and IRR techniques. It is difficult to choose one approach
over the other because the theoritical and practical strenghts of the approaches differ. Clearly,
it is wise to evaluate NPV and IRR techniques from both theoritical and practical point of
view.

Theoritical View
On theoritical view, NPV is better approach to capital budgeting. NPV measures how
much wealth a project creates for shareholders. Given that the financial managers
objective is to maximize shareholder wealth, the NPV approach has the clearest link
to this objective and, therefore, is the gold standard for evaluating investment
opportunities. In addition, certain mathematical properties may cause a project with a
nonconventional cash flow pattern to have multiple IRRs more than one IRR.
Multiple IRR is more than one IRR resulting from a capital budgeting project with a
nonconventional cash flow pattern; the maximum number of IRRs for a project is

equal to the number of sign changes in its cash flows. When multiple IRRs occur for
nonconventional cash flows, the analyst faces the time-consuming need to interpret
their meanings so as to evaluate the project.
Practical View
Financial managers use the IRR approach just as often as the NPV method.The appeal
of the IRR technique is due to the general disposition of business people to think in
terms of rates of return rather than actual dollar returns. Because interest rates
profitability, and so on are most often expressed as annual rates of return, the use of
IRR makes sense to financial decision makers. They tend to find NPV less intuitive
because it does not measure benefits relative to the amount invested.

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?
Simple Inspection Cash Flow
Base on Exhibit 1, the ranking of the projects using simple inpection cash flow are:
Project
1
2
3
4
5
6
7
8

Sum of Cash
Flow
3310
2165
10000
3561
4200
2200
2560
4150

Excess of Cash Flow

1310
165
8000
1561
2200
200
560
2150

Rankin
g
V
VIII
I
IV
II
VII
VI
III

Payback Period
Base on Exhibit 1, the ranking of the projects using payback period are:
Project Payback Period
Ranking
1
year 7
IV
2
year 2
II
3
year 15
V
4
year 6
III
5
year 8
VII
6
year 1
I
7
year 2
II
8
year 7
IV
Using payback period there are two projects which have same ranking, like project 1 and 8
have ranking IV. This method show different ranking compare to simple inspection of cash
flow.

Profitability Index (PI)

The ranking of projects using PI are:
Project
PI
Ranking
1
1,04
VI
2
0,96
VIII
3
1,20
I
4
1,11
II
5
1,06
V
6
1,00
VIII
7
1,08
IV
8
1,09
III
This method show different ranking compare to simple inspection of cash flow.
Net Present Value(NPV)
The ranking of projects using NPV are:
Project
NPV
Ranking
1
73,09
VI
2
-85,45
VIII/reject
3
393,92
I
4
228,22
II
5
129,70
V
6
0,00
VII
7
165,04
IV
8
182,98
III
This method show different ranking compare to simple inspection of cash flow.
Internal Rate of Return (IRR)
The ranking of projects using IRR are:
Project
IRR
Ranking
1
10,87%
VI
2
6,31%
VIII
3
11,33%
IV
4
12,33%
II
5
11,12%
V
6
10,00%
VII
7
15,26%
I
8
11,41%
III
This method show different ranking compare to simple inspection of cash flow.
Quantitative Ranking Method :

Year
Payback Period (year)
NPV
IRR
PI

7
73,09
10,87%
1,04

2
-85,45
6,31%
0,96

15
393,92
11,33%
1,20

6
228,22
12,33%
1,11

8
129,70
11,12%
1,06

1
0,00
10,00%
1,00

2
165,04
15,26%
1,08

7
182,98
11,41%
1,09

Base on the table above, we can see the results of four quantitative methods which use to rank
the projects. The table show different ranking of the projects from each quatitative methods.
We need to choose four best projects that company should accept. First, we need to determine
the quantitative method which we will use to rank the projects. We choose NPV to rank the
projects. Since almost projects are independent projects,the company can accept all projects
with positive NPV. Project 7 and 8 are mutually exclusive. Therefore we need to determine
using NPV or IRR. We choose NPV method. Because the NPV method uses a reinvestment
rate close to its current cost of capital, the reinvestment assumptions of the NPV method are
more realistic than those associated with the IRR method. Also, on a purely theoretical basis,
NPV is the better approach because NPV measures how much wealth a project creates for
shareholders.
NPV also has an advantage over IRR when a project has non-normal cash flows. Nonnormal cash flows exist if there is a large cash outflow during or at the end of the project.
The presence of non-normal cash flows will lead to multiple IRRs. Hence, the IRR method
cannot be employed in the evaluation process. Mathematically, this problem will not occur if
the NPV method is employed. The NPV method will always lead to a singular correct acceptor-reject decision.
In conclusion, NPV is a better method for evaluating mutually exclusive projects than the
IRR method. The NPV method employs more realistic reinvestment rate assumptions, is a
better indicator of profitability and shareholder wealth, and mathematically will return the
correct accept-or-reject decision regardless of whether the project experiences non-normal
cash flows or if differences in project size or timing of cash flows exist.
For this case, we recommended project 3, 4, 8, and 7 that the company should accept. On
NPV result analysis, project 3, 4, 8, and 7 have the biggest positive value than other projects.
Conclusion

We cannot rank the projects simply by inspecting the cash flow.

NPV method is better to rank the mutually exclusisve projects.
Financial manager tend to use IRR.
We choose project 3, 4, 8, and 7 using NPV approach.