Skyline University College MBA Program Financial Management Case Study 10 marks

Question

Skyline University College MBA Program Financial Management Case Study 10 marks Date of release: 4/10/2017 Capital Budgeting Suppose you are a new capital-budgeting analyst for a company considering investments in the Date of submission: 30/10/2017 eight projects listed in the table below. 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 relevajit. No other project characteristics are deciding factors in the selection, except that management has determined that projects 3 and 4 are mutually exclusive All the projects require the same initial investment, $10 million. Moreover, all are believed to be of the same risk class. The weighted-average cost of capital of the firm has never been estimated. In the past, analysts have simply assumed that 8 percent was an appropriate discount rate (although certain officers of the company have recently asserted thatthe discount rate should be much higher). To stimulate your analysis, consider the following questions: 1. Can you rank the projects simply by inspecting the cash flows?Show your ranking? 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 the quantitative method? Does this ranking differ from the ranking obtained by simple inspection of the cash flows? Note: a. You can use an excel sheet for the calculation. b. For the Quantitative method you have to write the formula and explain how you made the calculations.

Explanation / Answer

a. It would be incorrect to rank the projects simply by inspecting the cash flows since the cash flows occur at varying times and the value of money decreases over a period. If the projects are ranked by looking at the cash flows, the ranking would be

Project 3,

Project 5 ,

Project 8

and Project 1 (Since projects 3 and 4 are mutually exclusive, we have picked 3 and left out 4)

b. We will use the present value analysis to determine which project should be undertaken. This is because by converting future cash flows into present values, the time value of money is taken into consideration and its effect is eliminated. All future cash flows are converted to the value of money at present and hence the values become comparable.

The NPV is computed using 8% discount rate and the excel NPV built-in function as follows

= NPV(8%, Cash flows years 1-15) - Initial investment

Accordingly, the computations are as follows

c. As per the above method, we will rank the projects according to the highest NPV since that provides the true benefit derived from the project in present value terms. Accordingly, the ranking will be

Project 3

Project 8

Project 5 and

Project 1

This ranking is different from what we observed by simple inspection the cash flows occur at different time periods and should not be summed up for comparison. Using the present value analysis will yield accurate results provided the assumptions of discounting are more or less correct.

Project 1 2 3 4 5 6 7 8 Initial investment -10000 -10000 -10000 -10000 -10000 -10000 -10000 -10000 Year 1 1650 8330 800 1400 11000 6000 -1750 2 1650 1670 1000 1400 4500 -300 3 1650 825 1750 1400 1500 300 4 1650 1975 1400 450 1750 5 1650 2160 1400 350 3500 6 1650 2200 1400 6000 7 1650 2210 1400 11250 8 5000 2220 1400 9 2230 1400 10 2240 1400 11 2250 1400 12 2255 1400 13 2255 1400 14 2260 1400 15 50000 -10000 1400 Sum of cash flows 16550 10825 50000 17805 21000 11000 12800 20750 Excess 6550 825 40000 7805 11000 1000 2800 10750 NPV $ 1,291.86 $(200.37) $ 36,296.30 $ 2,244.08 $ 1,983.27 $ 185.19 $ 1,173.30 $ 2,374.21

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