Many investment criteria commonly used in the past have not provided very effect

Question

Many investment criteria commonly used in the past have not provided very effective guidance for spending investment dollars most efficiently. Discounted cash flow techniques, such as present worth and internal rate of return, represent improvements over some of the simpler measures and are becoming widely accepted, though perhaps not always understood. In capital-budgeting situations, where one suffers funds limitations, even present worth and internal rate of return fall short of what the decision maker needs. Neither will give proper comparisons among projects. Productivity index and growth rate provide ranking measures that can help in maximizing the worth of the firm by making sure the best projects get to the top of the list To illustrate the problems that confront people in capital allocation, let us dream up some independent projects with greatly differing cash-flow patterns (see table below). We then calculate several of the well-known economic indices and see what they lead to. To simplify, assume that each of the 11 projects requires only one investment, and that is required at time zero. Further, each project will be considered as having a 10-year length. Calculate discounted pay-back period (at three discount rates), internal rate of return, present worth (at three discount rates),growth rate of return (at three discount rates), and profitability index (at three discount rates). We have only $3,000 and must choose among these 11 projects. We would need a full $10,000 to get into all the investments, so clearly we must find some way to decide which projects merit our attention for the cash at hand. Rank all projects based on different yardsticks, then select the best projects based on your budget. Discuss your selection preferences based on advantage and drawbacks of different criterion (The three discount rates are: 5%, 10%, and 15%)

Explanation / Answer

As per the calculated values the selection criteria is based on Net present Value, Pay back period and Internal Rate of Return and Discount Rate. If Payback period is our criteria then we can choose projects which has low payback period adn relatively high NPV. In the same way, if Interna Rate of Return and Discount rates are priority then we can chose a high IRR and low Discount Rate projects which can give maximum NPV give IRR>Discount rate else project will have negative NPV and ranked priority can be set based on individual need.

Year P Q R S T U V W X Y Z 0 -1000 -1000 -1000 -1000 -1000 -1000 -1000 -500 -1000 -1000 -500 1 500 600 25 10 800 700 0 0 900 210 0 2 400 400 50 20 300 500 0 0 200 210 10 3 300 300 50 50 100 200 100 25 100 210 15 4 200 200 100 100 50 100 100 25 50 210 25 5 100 50 200 200 50 50 100 50 50 210 50 6 50 20 300 300 20 10 300 150 10 210 150 7 40 10 400 400 20 10 500 250 10 210 250 8 30 10 500 500 10 10 500 350 10 210 350 9 20 5 500 500 10 10 500 350 0 210 350 10 10 5 100 400 10 10 500 250 0 210 300 IRR(=IRR(C2:C12)) 22% 25% 12% 13% 20% 28% 14% 15% 20% 16% 15% Discount Rate Payback period Between 2 and 3 Years 2 Years Between 6 and 7 years Between 6 and 7 years Between 1 and 2 years Between 1 and 2 years Between 7 and 8 years Between 8 and 9 years Between 1 and 2 years Between 3 and 4 years Between 8 and 9 years 5% NPV(=NPV(A15,C2:C12)) 424.88 411.62 553.89 689.77 237.33 426.97 756.09 463.74 215.79 591.97 493.39 10% NPV(=NPV(A16,C2:C12)) 258.45 267.46 138.69 208.91 136.23 293.40 245.02 170.87 126.58 263.96 189.08 15% NPV(=NPV(A17,C2:C12)) 133.20 155.65 -122.26 -88.84 57.78 188.67 -70.01 -8.58 55.99 46.91 3.02

Related Questions

Navigate

• Browse (All)
• Browse M
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.