Actually, we can rank the projects by simply inspecting the cash flows. However, it is not a good method to rank the projects. In order to ensure that the investment projects selected have the best chance of increasing the value of the firm, we need tools to evaluate the merits of individual projects and to rank competing investments. In this case, our group using some tools which are Payback Period, Net Present Value (NPV) , Profitability Index (PI), and Internal Rate of Return (IRR).
We are only using quantitative considerations that we think to be relevant and no other project characteristics are deciding factors in our selection of the best four projects. Payback Period NPV PI IRR Sum of cash flow Benefits Excess of cash flow over initial investment Project 1 6 years 22 days $ 73. 09 104% 10. 87% 3310 1310 Project 2 2 years ($ 85. 45) 96% 6. 31% 2165 165 Project 3 15 years $ 393. 92 120% 400% 10000 8000 Project 4 6 years 18 days $ 228. 82 111% 12. 33% 3561 1561 Project 5 7 years 1 month 20 days $ 129. 70 106% 11. 12 % 4200 2200 Project 6 1 year 0 100% 10% 2200 200.
Project 71 year 10 months 20 days $ 165. 04 108% 15. 26% 2560 560 Project 8 6 years 14 days $ 182. 98 109% 11. 41% 4150 2150 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 assume that the appropriate discount rate is ten percent for our calculations. After calculating it, we have found the number for every tool on every project, and rank the projects.
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Even project’s ranking using different methods give a different ranking. Therefore, we are basing our rankings only from the results that 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. Most important, The NPV measures how much wealth a project creates or destroys for shareholders. The NPV approach has the clearest link to maximize shareholder wealth and become the “gold standard” for evaluating investment opportunities.
Because we are using the NVP method, the ranking of the project is: Ranking 1 Ranking 2 Ranking 3 Ranking 4 Ranking 5 Ranking 6 Ranking 7 Ranking 8 Project 3 Project 4 Project 8 Project 7 Project 5 Project 1 Project 6 Project 2 Therefore, the best four projects are Project 3 (NPV = $393. 92), Project 4 (NPV = $228. 82), Project 8 (NPV = $182. 98), and Project 7 (NPV = $165. 04) What kinds of real investment projects have cash flows similar to those in Exhibit? Project 1 is mostly similar to 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 zero coupon bond where you can purchase the bond at a specific price and you receive a big cash inflow at the end of the maturity period. The following projects 4, 7, and 8 are closely similar to an investment in machinery, which generates positive cash for you for a certain period of time. After a while, you can sell that off and receive some more cash.
(A) The payback is 35,000/5,000= 7 years Computation of the NPV : NPV= -35,000 + Σ 5,000 / ( 1 + 12%)^ 15 i=1 NPV = $- 945. 67 Computation of the IRR : 0= -35,000 + Σ 5,000 / ( 1 + IRR)^ 15 i=12 IRR= 11.49% The NPV of this project is negative and the IRR is lower then the Cost of Capital (12%) Rainbow products shouldn’t go for it. (B) Based on the perpetuity formula we can compute the PV in this ...
There might be some additional cash outflows initially to get the machinery going. Project 5 is similar to annuity in an machinery investment Recommendation Based on case analysis, we have already ranked the project and know the best four projects which are the projects that the company should accept. Ranking 1 is project 3 which is related to zero coupon bond. Ranking 2 until Ranking 4 are project 4, 8, and 7 which are an investment in machinery. We suggest that the company accept project 3 because it has the highest NPV which is $ 393. 92.