Case Study 1

Case Study 1

Due on Nov, 1st 2015

Real World Cases

Investment

Percentage of

Average Score on 0-4 Scale

Criterion

Firms That

(0=never use; 4=always use)

Always or

Almost Always

All Firms

Small Firms

Large Firms

76

3.1

2.9

3.4

Net present value

75

3.1

2.8

3.4

Payback period

57

2.5

2.7

2.3

Profitability index

12

0.8

0.9

0.8

Use Creiterion

Internal rate of

return

Source: J.R. Graham and C.R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field”,

Journal of Financial Economics, May 2001, pp.187-243.

Case Study 1

A: Investment Criteria and Discounted Cash Flow

The Investment Detective

The essence of capital budgeting and resource allocation is a search for good

investments in which to place the firm’s capital. 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

1

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 percent was

an appropriate discount rate.

Consider the following questions:

1 Can you rank the projects simply by inspecting the cash flows?

2 What criteria might you use to rank the projects? Which quantitative ranking

methods are better? Why?

3 What is the ranking you found by using quantitative methods? Does this ranking

differ form the ranking obtained by simple inspection of the cash flows?

Exhibit 1 Projects’ Cash Flows (dollars in thousands)

Project

1

2

3

4

5

6...