The Investment Detective

Student name: Agung Budi Rudiantoro

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

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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 1 2 3 4 5 6 7 8
Number
Initial ($2,000) ($2,000) ($2,000) ($2,000) ($2,000) ($2,000) ($2,000) ($2,000)
Investment
Year 1 $330 $1,666 0 $160 280 $2,200 $1,200 ($350)
2 330 334 0 200 280 900 (60)
3 330 165 0 350 280 300 60
4 330 0 395 280 90 350
5 330 0 432 280 70 700
6 330 0 440 280 1,200
7 330 0 442 280 2,250
8 1,000 0 444 280
9 0 446 280
10 0 448 280
11 0 450 280
12 0 451 280
13 0 451 280
14 0 452 280
15 10,000 (2,000) 280

Sum of Cash $3,310 $2,165 $10,000 $3,561 $4,200 $2,200 $2,560 $4,150
Flow
Benefits
Excess of
Cash Flow
Over $1,310 $165 $8,000 $1,561 $2,200 $200 $560 $2,150
Initial
Investment

Answering case question:

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 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.
Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Project 7 Project 8
Sum of Cash $3,310 $2,165 $10,000 $3,561 $4,200 $2,200 $2,560 $4,150
Flow Benefits

Rank of each 5 8 1 4 2 7 6 3
project

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 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

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 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

NPV

Rank of 6 8 1 2 5 7 4 3
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
method these two projects have a positive amount of money without considering the time value
of money and a cost of capital.

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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:

Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Project 7 Project 8
NPV $73.09 ($85.45) $393.92 $228.22 $129.70 $0.00 $165.04 $182.98
IRR 10.87% 6.31% 11.33% 12.33% 11.12% 10.00% 15.26% 11.41%
MIRR 10.49% 8.41% 11.33% 10.65% 10.46% 10.00% 11.76% 11.18%
5 8 2 4 6 7 1 3
Rank based
to return %

Payback 6.06 2.00 14.20 6.05 7.14 0.91 1.89 6.04

period
Discounted 7.84 0.00 14.83 9.09 13.15 1.00 2.73 6.84
payback
period
4 8 7 5 6 1 2 3
Rank based
time to cover
the cost

Profitability 3.65% -4.27% 19.70% 11.41% 6.49% 0.00% 8.25% 9.15%

Index
EAA $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.

Rate NPV 1 NPV 3 NPV 4 NPV 5 NPV 7 NPV 8

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 0% $1,310 $8,000 $1,561 $2,200 $560 $2,150
1% $1,144 $6,613 $1,405 $1,882 $515 $1,884
2% $989 $5,430 $1,253 $1,598 $471 $1,637
3% $845 $4,419 $1,105 $1,343 $428 $1,408
4% $711 $3,553 $962 $1,113 $387 $1,194
5% $586 $2,810 $825 $906 $347 $995
6% $470 $2,173 $693 $719 $309 $809
7% $360 $1,624 $568 $550 $271 $636
8% $258 $1,152 $449 $397 $235 $475
9% $163 $745 $336 $257 $199 $324
10% $73.09 $394 $228 $130 $165 $183
11% ($11) $90 $127 $13 $132 $51
12% ($90) ($173) $30 ($93) $99 ($72)
13% ($164) ($401) ($60) ($191) $68 ($188)
14% ($234) ($599) ($146) ($280) $37 ($296)
15% ($300) ($771) ($227) ($363) $8 ($397)
16% ($362) ($921) ($304) ($439) ($21) ($493)
17% ($421) ($1,051) ($376) ($509) ($50) ($582)
18% ($476) ($1,165) ($444) ($574) ($77) ($666)
19% ($528) ($1,264) ($509) ($635) ($104) ($745)
20% ($578) ($1,351) ($570) ($691) ($130) ($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 3 NPV 4

NPV 5 NPV 7 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.

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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).

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