The Investment Detective case 17 2 PDF

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The Investment Detective Case 17

Wright State University MBA – 7300 – 01 Professor name: Dr. Carol Wang Student name: Salman Saeed Alaali

Alaali- The Investment Detective case 17

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According to the Investment Detective case (The essence of capital budgeting and resource allocation is a search for good invest- ments 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 invest- ment 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 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. 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 require 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) Exhibit 1 The Investment Detective Project Free Cash Flows (in $ Thousands) Project Number Initial Investment Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

1

2

3

4

5

6

7

8

($2,000)

($2,000)

($2,000)

($2,000)

($2,000)

($2,000)

($2,000)

($2,000)

$330 330 330 330 330 330 330 1,000

$1,666 334 165

0 0 0 0 0 0 0 0 0 0 0 0 0 0 10,000

$160 200 350 395 432 440 442 444 446 448 450 451 451 452 (2,000)

280 280 280 280 280 280 280 280 280 280 280 280 280 280 280

$2,200

$1,200 900 300 90 70

($350) (60) 60 350 700 1,200 2,250

Sum of Cash Flow Benefits Excess of Cash Flow Over Initial

$3,310

$2,165

$10,000

$3,561

$4,200

$2,200

$2,560

$4,150

$1,310

$165

$8,000

$1,561

$2,200

$200

$560

$2,150

Alaali- The Investment Detective case 17

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Investment

Answering case question: 1. Can you rank the projects simply by inspecting the cash flows? Yes, we can be ranking the project by inspecting the cash flow, however it is not enough method to use to select the most beneficially project, cash flow method good for someone how does not know the quantitative analytical method because the quantitative analytical will consider the risk of the time value of money and the capital cost. We can find below the ranking of the projects under cash flow method. Sum of Cash Flow Benefits Rank of each project

Project 1 $3,310

Project 2 $2,165

Project 3 $10,000

Project 4 $3,561

Project 5 $4,200

Project 6 $2,200

Project 7 $2,560

Project 8 $4,150

5

8

1

4

2

7

6

3

2. What criteria might you use to rank the projects? Which quantitative ranking methods are better? Why? For analyzing the date of the projects, we can use the quantitative ranking methods to select the best project benefit. In the quantitative ranking methods, we have six popular way to analyze the date, we have NPV, EAA, MIRR, IRR, discount payback, payback and PI methods. Each criteria under the quantitative methods has advantage and disadvantage.  NPV it is stand for Net Present Value, it is the difference between the present value of cash inflows and the present value of cash outflows, and this method consider the capital cost of the projects. We used the NPV to select the best project, if NPV greater than or equal to zero, so it is good to accept the projects, but if the NPV is negative we should reject the projects. This method is most popular in real life work, and most of the managers are select the project based to this method, if the projects are independent with positive NPV they can accept the project, but if the projects are mutually exclusive such as project 7 and 8 from the case, we select the highest positive NPV. The disadvantage of the NPV method is not considering the time of the projects.  EAA it is stand for Equivalent Annual Annuity, EAA has most of NPV characteristics. However, EAA assume the project will continue forever which is not correct in real life. Most how use EAA method are compare the date for two projects because by EAA you can compare two projects such as 7 and 8 with different data level. The level of EAA is stronger than NPV in evolution method.  IRR it is stand for Internal Rate of Return, it is the discount rate that forces a project’s NPV to equal zero. We accept the project if the IRR greater than WACC and we reject the

Alaali- The Investment Detective case 17

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project if it less than WACC. The disadvantage of this method, it is assume that is the rate of the return as a same for all the year of the project which is not correct in real life.  MIRR it is stand for Modified Internal Rate of Return, this method better than IRR, it is based to assumption that the cash flows are reinvested at the WACC. We accept the project at MIRR greater than or equal to WACC and we reject the project if MIRR is less than WACC.  Discount Payback and Payback methods, these two methods measure the time by year to cover the project cost. Payback method ignore the time value and cost of capital. However, Discount Payback method is considering the time vale of money and capital cost. Always Discount Payback method is better than Payback method because it take the risk of the time value of money and capital cost. Finally, there is no way of telling how low the payback must be to justify project acceptance.  PI stand for Profitability Index, we accept the project when PI is greater than 1 and we reject if it less. A Profitability Index greater than 1 is equivalent to a project’s having positive NPV. It is found by dividing the project’s present value of future cash flow by its initial cost. As a result, when we need to accept or reject a project, always we need to considering all the risk of the projects. Most companies use type one and type tow error to accept or reject the projects. However, the NPV is the primarily method and most experienced manger use it in real life because it addresses directly to the central goal of financial management which is maximizing shareholder wealth. 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? At the beginning we will see the NPV of all projects in below table. Project 1

Project 2

Project 3

Project 4

Project 5

Project 6

Project 7

Project 8

$73.09

($85.45)

$393.92

$228.22

$129.70

$0.00

$165.04

$182.98

6

8

1

2

5

7

4

3

NPV Rank of each project

We can see from NPV table the rank of each project. We can reject project 2 because it has negative NPV. Also as what we see in project 6, it has zero NPV whish is very low and it will risky if you select that project because you will not get any finical benefit in that project. How ever if you use only NPV method you can accept all the other projects, starting from the highest NPV to the zero as ranking in the table. Comparing by cash flow method and quantitative methods, we have a significant different between both ranking, NPV method shows in projects 2 and 6 are not profitable but in cashflow Alaali- The Investment Detective case 17

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method these two projects have a positive amount of money without considering the time value of money and a cost of capital. On the other hand, when we analyze the other data of the quantitative methods and see the other risk such as the payback, cost of capital and time value, may we have different ranking for the projects. Look at the table below for more analyzing: NPV IRR MIRR Rank based to return % Payback period Discounted payback period Rank based time to cover the cost Profitability Index EAA

Project 1 $73.09 10.87% 10.49% 5

Project 2 ($85.45) 6.31% 8.41% 8

Project 3 $393.92 11.33% 11.33% 2

Project 4 $228.22 12.33% 10.65% 4

Project 5 $129.70 11.12% 10.46% 6

Project 6 $0.00 10.00% 10.00% 7

Project 7 $165.04 15.26% 11.76% 1

Project 8 $182.98 11.41% 11.18% 3

6.06

2.00

14.20

6.05

7.14

0.91

1.89

6.04

7.84

0.00

14.83

9.09

13.15

1.00

2.73

6.84

4

8

7

5

6

1

2

3

3.65%

-4.27%

19.70%

11.41%

6.49%

0.00%

8.25%

9.15%

$13.70

($34.36)

$51.79

$30.01

$17.05

$0.00

$43.54

$37.59

Regarding to the case, all the projects have the same amount of instill cost, risk and capital cost. The different between each project is the cash flow and out flow. When we have more than one method to select the project, it is hard to find which one is the best because each investor is looking to have best benefit in short term, however not all the industry can gain the benefit in short term because some of industry gain the benefit in long term. Also, most of time the investor try to select the best project between different projects as what we have in the case between project 7 and 8. Always, the investor select between two project because the investor does not has enough sources to do all the projects. Here in the case, we should choose between two project 7and 8. We can accept both projects because the return is more than cost, but because these two projects are mutually exclusive, so I will select project 7. Project 7 has more return (IRR & MIRR) with short period to cover the cost of the project (Payback & Discount Payback). Also, Project 7 has more in EAA than project 8, so project 7 is better because it is cover most of the risk in the time and benefit. Also, we can analyze the data of WACC to see which project will reach the point of the breakeven at which level of IRR. Look at the table and chart below.

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Rate 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

NPV 1 $1,310 $1,144 $989 $845 $711 $586 $470 $360 $258 $163 $73.09 ($11) ($90) ($164) ($234) ($300) ($362) ($421) ($476) ($528) ($578)

NPV 3 $8,000 $6,613 $5,430 $4,419 $3,553 $2,810 $2,173 $1,624 $1,152 $745 $394 $90 ($173) ($401) ($599) ($771) ($921) ($1,051) ($1,165) ($1,264) ($1,351)

NPV 4 $1,561 $1,405 $1,253 $1,105 $962 $825 $693 $568 $449 $336 $228 $127 $30 ($60) ($146) ($227) ($304) ($376) ($444) ($509) ($570)

NPV 5 $2,200 $1,882 $1,598 $1,343 $1,113 $906 $719 $550 $397 $257 $130 $13 ($93) ($191) ($280) ($363) ($439) ($509) ($574) ($635) ($691)

NPV 7 $560 $515 $471 $428 $387 $347 $309 $271 $235 $199 $165 $132 $99 $68 $37 $8 ($21) ($50) ($77) ($104) ($130)

NPV 8 $2,150 $1,884 $1,637 $1,408 $1,194 $995 $809 $636 $475 $324 $183 $51 ($72) ($188) ($296) ($397) ($493) ($582) ($666) ($745) ($819)

Chart Title $10,000 $8,000 $6,000 $4,000 $2,000 $0 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% ($2,000) NPV 1 NPV 5

NPV 3 NPV 7

NPV 4 NPV 8

We can see from the above chart, project 3 has the highest return, however project 7 has the lowest breakeven. Also, we exclude projects 2 and 6 because they have low return which they will not cover the cost of the capital, so no benefit to invest in these tow projects. By going back to all the data, we have from quantitative methods, we can rank the best four projects (3,7,4 and 5). I rank these projects based to EAA and MIRR because these tow methods will give you the best project return, however each investor looking for the time payback different up to the industry and changing in the market, so we ignore the time payback in this ranking. Alaali- The Investment Detective case 17

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4. What kinds of real investment projects have cash flows similar to those in Exhibit1?

I.

Project 1: Drilling company such as Halliburton company (drilling service for 8 year).

II.

Project 2: retail store for clothes such as (H&M).

III.

Project 3: Tesla company (electric car segment).

IV.

Project 4: Refinery plant such as exxon company (gasoline product line).

V.

Project 5: Insurance company such as (State Farm life insurance service).

VI.

Project 6: Grocery store such as (Target open for 1 year then they clos it).

VII.

Project 7: Communication company such as AT&T company (plan phone).

VIII.

Project 8: Car manufactory such as GMC (trucks line product).

Alaali- The Investment Detective case 17

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