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Rev. Oct. 3, 2017

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The Investment Detective

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Teaching Note

Synopsis and Objectives

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This case presents the cash flows of eight unidentified investments, Suggestions for complementary
all of equal initial investment size. The student’s task is to rank the cases on measures of investment
projects. The first objective of the case is to motivate students to attractiveness: “Fonderia del
examine critically the principal capital-budgeting criteria. A second Piemonte S.p.A,” (UVA-F-1764);
objective is to have students consider the problem that arises when net on ranking problems: “Victoria
present value (NPV) and internal rate of return (IRR) disagree as to the Chemicals (B),” (UVA-F-1544);
ranking of two mutually exclusive projects. Finally, the case is a vehicle and “Euroland Foods S.A.,”
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for introducing the problem created by attempting to rank projects of (UVA-F-1356).1
unequal life and the solution to that difficulty—the equivalent-annuity
criterion.

Suggested Questions for Advance Assignment to Students

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The case is self-explanatory and can be used without the benefit of additional study questions.

Supplementary Spreadsheets

For students: UVA-F-0813X

No

For instructors: UVA-F-0813TNX

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1 Robert F. Bruner and Michael J. Schill, “Fonderia del Piemonte S.p.A,” UVA-F-1764 (Charlottesville, VA: Darden Business Publishing, 2016);

Robert F. Bruner, “Victoria Chemicals PLC (B): Merseyside and Rotterdam Projects,” UVA-F-1544 (Charlottesville, VA: Darden Business Publishing,
2008); Casey Opitz and Robert F. Bruner, “Euroland Foods S.A.,” UVA-F-1356 (Charlottesville, VA: Darden Business Publishing, 2001).

This teaching note was written by Robert F. Bruner. The comments of Professors Kenneth Eades and Raghu Rau are gratefully acknowledged. Copyright
© 1989 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted
in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

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Hypothetical Teaching Plan

The following teaching plan is designed for an 80-minute class:

1. Before doing any calculations, can we rank the projects simply by inspecting the cash flows?

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2. What analytical criteria can we use to rank the projects? How do you define each criterion? Put the numbers up on the
board.
3. Which of the two projects, 7 or 8, is more attractive? How sensitive is our ranking to the use of high discount rates? Why
do NPV and IRR disagree?
4. What rank should we assign to each project? Why do payback and NPV not agree completely? Why do average return
on investment and NPV not agree completely? Which criterion is best?

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5. Are those projects comparable on the basis of NPV? Because the projects have different lives, are we really measuring the
“net present” value of the short-lived projects?

The instructor may choose to close the class with a summary of the key insights raised during class.

Case Analysis
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Motivation for the ranking

The case is purposely ambiguous about the need for ranking the projects. The reason for this is that it
simplifies the task for the student and gives the instructor greater latitude in conducting the discussion. The
case could have been motivated by a capital constraint and the need to choose projects to fill the constrained
budget. But capital rationing raises a number of challenging problems beyond the scope of an introductory
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case. The instructor’s aim in this discussion should be to survey and exercise the range of project evaluation
measures.

Simple ranking of projects

Exhibit TN1 presents an outline of the NPVs, IRRs, accounting returns on Discussion
investment (ROI), payback, present value (PV) index, and equivalent annuity. questions
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(Exhibit TN1 identifies the method of computing ROI, PV index, and equivalent 1 and 2
annuity.) Because the result is a blizzard of numbers, the instructor will want to narrow
down the choice of method early in the class by reviewing the weaknesses of each
analytical alternative. The key points should be the following:
 IRR: Possibly incorrect opportunity cost assumption. Violates value additivity. Multiple IRRs are
possible.

 NPV: May be difficult to explain.

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 ROI: Often computed on profits, not cash flow. Ignores time profile of flows and the time value of
money.

 Payback: Ignores time value of money, although it is a proxy for the liquidity or duration of an
investment and is sometimes used in conjunction with NPV.

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After such a review, students lose allegiance to ROI and payback, which makes the ranking by time-value
criteria easier to accomplish.

The mutually exclusive ranking: projects 7 and 8

The place to begin the ranking of all projects is to choose between the mutually Discussion

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exclusive projects. Unfortunately, as Exhibit TN1 shows, IRR and NPV (at the 10% question 3
hurdle rate) disagree on the ranking of projects 7 and 8. At higher discount rates, however,
IRR and NPV rank the projects consistently.

Exhibit TN2 uses a graph to show what is happening. The value functions of projects 7 and 8 cross over;
hence, the rankings change as the discount rate varies from one side to the other of the crossover point.

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The reason the value functions cross over is that the time profiles of the two projects are very different.
Project 7 (see case Exhibit 1) offers large cash flows early, which dwindle to nothing as time passes—like a
mine in which the miners extract the easiest and richest ore first. Project 8 requires continuing investment in
the early years and then offers rising positive cash flows—rather like an orchard or a consumer brand name.
At high discount rates, project 8’s large future cash flows have a relatively smaller present value than they do at
the low discount rates. Project 7 is much less affected by higher discount rates, because its most significant cash
flows appear early in its life.
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The standard approach to the appearance of a crossover problem is to rely on the ranking by NPV, because
the discount rate is held constant across both projects. If the discount rate is reasonably chosen, then,
presumably, the implicit reinvestment-rate assumption is also reasonable. Ranking by IRR invites error to the
extent that the reinvestment-rate assumption is not reasonable. The NPV criterion makes the correct
assumption that projects of equal risk should be discounted at the same rate.
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The problem of unequal scale

Superficially, all eight projects are of equal size; that is, the initial outlay in all cases is Discussion
$2,000. Observant students, however, will point out that, in projects 4 and 8, the outlays question 4
extend farther out in time. How one views those outlays is a matter of debate, but, from
one perspective, they represent continuing investment. According to this view, projects 4
and 8 are of larger scale than the other projects. The PV index adjusts for scale differences
by showing the present value of benefits per dollar of outlay.
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The problem of unequal lives

In introductory classes, I ordinarily skip the treatment of unequal lives. It is a rather challenging subject for
weaker students, and can obscure the more important lessons in the case. Moreover, most project analysts go
to the trouble to adjust for unequal lives only when projects are truly mutually exclusive (which six of the eight
projects are not in this case), and when project lives differ significantly. Where the instructor has more time or
a more advanced class of students, the following comments will be relevant.
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Comparisons based on standard NPV ignore the inequality of project lives such as those in the case. Simply
put, short-lived projects could be replicated within the life of the longest project (for example, project 6 could
be replicated 15 times within the life of project 3), producing very different time profiles of cash flows for the
projects.

One solution to this problem is the so-called replacement-chain approach, in which short-lived projects
are replicated out to a horizon common with the long-lived projects; the NPV on the entire chain is then

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calculated and compared with the NPV of the other chain. This approach can be cumbersome, however, in
problems with many alternative investments. For instance, in this case, the common horizon for all eight
projects is 840 years (we have projects of 1, 3, 5, 7, 8, and 10 years, so the common horizon is equal to
1 × 3 × 5 × 7 × 8 × 10).

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An easier and intuitively appealing approach is to compare the “equivalent annuity” among all the projects.
The equivalent annuity is the level annual payment across a project’s specific life that has a present value equal
to that of another cash flow stream. Projects of equal size but different life (such as those in this case) can be
ranked directly by their equivalent annuity.2

Exhibit TN1 presents the equivalent annuities for the eight projects. Here we observe another ranking
change: Project 8 dominates project 7 on the basis of NPV, but on the basis of equivalent annuities, project 7
is more attractive. (A similar reversal occurs between project 4 and project 7 or 8.) The ranking changes because

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the simple NPV calculation ignores the unequal lives within the pairs of projects. One could replicate project 7
three times within project 4, and thus realize more value through 7 than 4.

The notion of project replication can be extended to one last important insight: every project can be viewed
as a series of mutually exclusive projects wherever it is possible to end and restart the investment cycle at any
point in time. This is the perspective of the major wood-products companies that must determine the optimal
time to harvest trees and then replant. The flexibility to enter and exit projects is valuable—as is any flexibility
to shift the flows of cash in time. For instance, suppose that it is possible to change the last three cash flows
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for project 7 from 300, 90, 70, to 320, 120, 12.8. The result is that NPV remains unchanged at 165, as does the
equivalent annuity at 43.5. Because the last cash flow, 12.8, is so small, consider the possibility of ending the
project one year early and forgoing the 12.8. The NPV of the shortened project 7 falls to 157, but equivalent
annuity increases to 49.6. The higher equivalent annuity indicates that most of the project’s value is created earlier
in its life. This illustrates the attractiveness of such business actions as harvesting trees before full maturity or
selling a venture capital investment before it achieves dominance in its market.
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Approaches that adjust for unequal lives may entail unrealistic implicit assumptions. For instance, the
replacement-chain approach and equivalent annuity assume replication of the identical project for an identical
outlay. But changes in technology, markets, or organization over time might dictate the replacement with a very
different asset (and outlay) than contemplated today. Inflation will likely cause the replacement asset to have a
higher outlay in the future. Finally, in unusual cases, it simply may be impossible to replicate the project at the
end of its life (for example, a mine for rare minerals). The point of discussing those assumptions should be to
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help students gain a sense of the limitations of adjustments for unequal lives.

In our experience teaching this case to novice students at the Darden Graduate School of Business
Administration at the University of Virginia, the equivalent annuity is easily seized by students as the criterion
of choice—as the saying goes, “To the child with a new hammer, every problem looks like a nail.” We
discourage widespread application of the equivalent annuity criterion, because of the weaknesses cited earlier.
Our closing message is that unless the lives of mutually exclusive projects are materially unequal, make decisions
using NPV rather than equivalent annuity.
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2
The equivalent-annuity approach is also known as the equivalent annual cost or the equivalent annual cash flow. Good treatments of this technique
can be found in: Ross, Westerfield, and Jaffee, Corporate Finance, 3rd ed. (New York: McGraw-Hill/Irwin, 1993), 204–205; Emery and Finnerty, Principles
of Finance (1991), 318–322; and Brealey and Myers, Principles of Corporate Finance, 5th ed. (New York: McGraw-Hill/Irwin, 1996), 128.

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Ranking the projects

After the students wrestle with the full range of ranking criteria, the equivalent annuity Discussion
criterion will probably gain the greatest acceptance (as it should). Based on equivalent question 5
annuities, we would rank the projects as follows:

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Project Number Ranking
1 5th
2 7th
3 2nd
4 3rd
5 4th
6 6th

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8 1st

There is no eighth ranking: project 7 was eliminated by the mutually exclusive choice between 7 and 8.

Naming the projects

The case questions invite the students to imagine real investment projects that have cash flows similar to
those in the case. Hypothesizing this way adds realism to the discussion but should be saved until the end of
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class because: (1) the projects that students mention often have widely varying risk levels, and (2) students are
often tempted to apply different discount rates to the projects in the case, thus, leading the discussion astray.
Here is a sampling of project types:

Project Number Type

1 Partially amortizing bond
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2 Advertising campaign
3 Zero-coupon bond
4 Nuclear power plant; pesticide factory
5 Home mortgage
6 One-year bond
7 Mine
8 Orchard
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Exhibit TN1
The Investment Detective
Comparative Analysis of Investments

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1. Project free cash flows (in thousands of dollars)

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 $2,2001 $1,200 $(350)

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2 330 3341 200 280 9001 (60)
3 330 $ 165 350 280 300 60
4 330 395 280 90 350
5 330 432 280 $ 70 700
6 330 4401 280 1,200
7 3301 442 280 $2,2501
8 $1,000 444 2801
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9 446 280
10 448 280
11 450 280
12 451 280
13 451 280
14 452 280
15 $10,0001 $(2,000) $ 280
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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
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investment $1,310 $165 $8,000 $1,561 $2,200 $200 $560 $2,150

1 Indicates year in which payback is accomplished.

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Exhibit TN1 (continued)

2. Analysis

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Project number 1 2 3 4 5 6 7 8

Total life of investment 8 3 15 15 15 1 5 7

Payback (years) 7 2 15 6 8 1 2 7

Average ROI2 20.7% 36.1% 33.3% 11.9% 14.0% 110.0% 25.6% 29.6%

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Net present value at:

10% $73 $(85) $394 $228 $130 0 $165 $183

11% (11) (107) 90 127 13 $(18) 132 51
12% (90) (129) (173) 30 (93) (36) 99 (72)
14% $(234) $(170) $(599) $(146) $(280) $(70) $37 $(296)
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Internal rate of
return 10.9% 6.3% 11.3% 12.3% 11.1% 10.0% 15.3% 11.4%
PV index3 1.037 0.957 1.197 0.706 1.065 1.000 1.083 1.563
Equivalent
annuity4 $13.7 $(34.4) $51.8 $30.0 $17.1 0 $43.5 $37.59
Equiv. annuity
(to infinity) $137.0 $(343.6) $517.9 $300.1 $170.5 0 $435.4 $375.9
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2 Average return on investment is calculated as the average of the cash flows over the life of the project divided by the $2,000 upfront investment.
3 The PV index is calculated as the present value of all inflows (at a 10% discount rate) divided by the present value of all outflows. Ordinarily, the
PV index will rank projects identically to the standard NPV except where outflows occur in later years, as in projects 4 and 8; in those cases, the PV
index changes the ranking significantly.
4 The equivalent annuity is that constant annual payment over the life of an investment that yields a present value (at discount rate, r, or 10% in this
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case) that is just equal to the net present value of the entire cash flow stream. The equivalent annuity is solved for by this equation:

Equivalent PV (Cash flows)

=
Annuity n-year annuity present-value factor

where the n-year annuity present-value factor (the present value of an annuity of $1.00 per period for n periods, or PVFA) is

1‫ ׃‬− 1
(1 + r)n
PVFA =
r
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Exhibit TN2
The Investment Detective
Graphic Comparison of Projects 7 and 8

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$2,500

$2,000
Net Present Value (thousands)

$1,500

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$1,000

$500

$0
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0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22%
($500)

($1,000)

($1,500)
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Project 7 NPVs Project 8 NPVs

No
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