
Concept explainers
The essence of capital budgeting and resource allocation is a search for good investments in which to place the firm's 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, therefore, is necessarily a detective who must winnow bad evidence from good. Much of the challenge is in knowing what quantitative analysis to generate in the first place.
Suppose you are a new capital-budgeting analyst fr a company considering investments in the eight projects listed in Exhibit 1. The CFO of your company has asked you to rank the projects and recommend the "four best" that the company should accept.
In this assignment, only the 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 the projects required the same initial investment, $2 million. Moreover, all are believed to be of the same risk class. The firm's weighted average cost of capital has never been estimated. In the past, analysts have simply assumed that 10% was an appropriate discount rate (although certain officers of the company have recently asserted that the discount rate should be much higher.)
To stimulate your analysis, consider the following questions:
1.) Can you rank the projects simply by inspecting the cash flow?
Exhibit 1 | |||||||||
The Investment Detective | |||||||||
Project number | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | |
Initial investment | $2,000 | $2,000 | $2,000 | $2,000 | $2,000 | $2,000 | $2,000 | $2,000 | |
Year | 1 | $330 | $1,666 | $160 | $280 | $2,200* | $1,200 | ($350) | |
2 | $330 | $334* | 200 | $280 | $900* | ($60) | |||
3 | $330 | 165 | 350 | $280 | 300 | $60 | |||
4 | $330 | 395 | $280 | 90 | $350 | ||||
5 | $330 | 432 | $280 | 70 | $700 | ||||
6 | $330 | $440* | $280 | $1,200 | |||||
7 | $330* | 442 | $280 | $2,250* | |||||
8 | $1,000 | 444 | $280* | ||||||
9 | 446 | $280 | |||||||
10 | 448 | $280 | |||||||
11 | 450 | $280 | |||||||
12 | 451 | $280 | |||||||
13 | 451 | $280 | |||||||
14 | 452 | $280 | |||||||
15 | $10,000 | $2,000 | $280 | ||||||
Sum of cash flow | |||||||||
benefits | $3,310 | $2,165 | $10,000 | $3,561 | $4,200 | $2,200 | $2,560 | $4,150 | |
Excess of cash flow | |||||||||
over initial investment | $1,310 | $165 | $8,000 | $1,561 | $2,200 | $200 | $560 | $2,150 | |
*Indicates year in which payback was accomplished |

Trending nowThis is a popular solution!
Step by stepSolved in 4 steps with 1 images

- While the NPV is proven to be the correct way of analyzing projects, it seems that its accuracy is enhanced by use of the IRR to determine how sensitive the NPV is to the cost of capital. Given this apparent reality that both tools contribute critical information to final business decisions, shouldn’t both the NPV and IRR be included in every analysis?arrow_forwardexplain why it is important to understand that capital budgeting is subject to the validity of the forecasted data. Additionally, explain whether this reduces the reliability of these types of tools. Are there any other alternatives, or are these tools some of the most reliable that currently exist?arrow_forwardWhat are the best functions to use when evaluating projects with uneven cashflows?arrow_forward
- I'm not sure if I am doing this correctly, also not sure which ones to choose for the last question.arrow_forwardHow can I explain these?arrow_forwardThe rationale for funds transfer pricing is that there are: Group of answer choices D. Less chances for controversy in organizations B. Controls that can be exercised over the dynamics of yield curves C. Controllable interest rate risks removed from business results A. Economies of scale in managing interest rate riskarrow_forward
- Which of the following limits the market from becoming a fully efficient market? New information takes time to process. Obtaining new information is costly. The existence of closed end investment companies. Both a. and b. are correct. All of the above answers are correct. None of the above answers is correct.arrow_forwardThe market for capital Firms require capital to invest in productive opportunities. The best firms with the most profitable opportunities can attract capital away from inefficient firms with less profitable opportunities. Investors supply firms with capital at a cost called the interest rate. The interest rate that investors require is determined by several factors, including the availability of production opportunities, the time preference for current consumption, risk, and inflation. Suppose the Federal Reserve (the Fed) decides to tighten credit by contracting the money supply. Use the following graph by moving the black X to show what happens to the equilibrium level of borrowing and the new equilibrium interest rate. Q1. Which tend to be more volatile, short- or long-term interest rates? Long-term interest rates 2. Short-term interest rates Q2. If the inflation rate was 3.20% and the nominal interest rate was 4.20% over the last year, what was the real rate of interest over…arrow_forwardSeveral factors affect a firm’s need for external funds. Evaluate the effect of each following factor and place a check next to each factor that is likely to increase a firm’s need for external capital—that is, its AFN (additional funds needed). Check all that apply. The firm increases its dividend payout ratio. The firm switches its supplier for the majority of its raw materials. The new supplier offers less favorable credit terms and thus reduces the trade credit available to the firm, resulting in a reduction in accounts payable. The firm improves its production system and increases its profit margin. Accounts payable and accrued liabilities represent obligations that the firm must pay off. Assuming everything else holds constant, if they increase, the firm’s AFN will_________ .arrow_forward
- Essentials Of InvestmentsFinanceISBN:9781260013924Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.Publisher:Mcgraw-hill Education,
- Foundations Of FinanceFinanceISBN:9780134897264Author:KEOWN, Arthur J., Martin, John D., PETTY, J. WilliamPublisher:Pearson,Fundamentals of Financial Management (MindTap Cou...FinanceISBN:9781337395250Author:Eugene F. Brigham, Joel F. HoustonPublisher:Cengage LearningCorporate Finance (The Mcgraw-hill/Irwin Series i...FinanceISBN:9780077861759Author:Stephen A. Ross Franco Modigliani Professor of Financial Economics Professor, Randolph W Westerfield Robert R. Dockson Deans Chair in Bus. Admin., Jeffrey Jaffe, Bradford D Jordan ProfessorPublisher:McGraw-Hill Education





