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

NPV of Rankings V-1st Y-2nd R-3rd The total Investment is $3000 and hence to be accepted

V=793.89

Y=621.56

R=581.58

Hence Total NPV=1997.03

When Discount rate is 5% Year P Discounting rate @5% Discounted Cash Flows Q Discounting rate @5% Discounted Cash Flows R Discounting rate @5% Discounted Cash Flows S Discounting rate @5% Discounted Cash Flows T Discounting rate @5% Discounted Cash Flows U Discounting rate @5% Discounted Cash Flows V Discounting rate @5% Discounted Cash Flows W Discounting rate @5% Discounted Cash Flows X Discounting rate @5% Discounted Cash Flows Y Discounting rate @5% Discounted Cash Flows Z Discounting rate @5% Discounted Cash Flows 0 -1000 1 -1000 -1000 1 -1000 -1000 1 -1000 -1000 1 -1000 -1000 1 -1000 -1000 1 -1000 -1000 1 -1000.00 -500 1 -500 -1000 1 -1000 -1000 1 -1000 -500 1 -500 1 500 0.9524 476.19 600 0.9524 571.43 25 0.9524 23.81 10 0.9524 9.52 800 0.9524 761.90 700 0.9524 666.67 0 0.9524 0.00 0 0.9524 0.00 900 0.9524 857.14 210 0.9524 200.00 0 0.9524 0.00 2 400 0.9070 362.81 400 0.9070 362.81 50 0.9070 45.35 20 0.9070 18.14 300 0.9070 272.11 500 0.9070 453.51 0 0.9070 0.00 0 0.9070 0.00 200 0.9070 181.41 210 0.9070 190.48 10 0.9070 9.07 3 300 0.8638 259.15 300 0.8638 259.15 50 0.8638 43.19 50 0.8638 43.19 100 0.8638 86.38 200 0.8638 172.77 100 0.8638 86.38 25 0.8638 21.60 100 0.8638 86.38 210 0.8638 181.41 15 0.8638 12.96 4 200 0.8227 164.54 200 0.8227 164.54 100 0.8227 82.27 100 0.8227 82.27 50 0.8227 41.14 100 0.8227 82.27 100 0.8227 82.27 25 0.8227 20.57 50 0.8227 41.14 210 0.8227 172.77 25 0.8227 20.57 5 100 0.7835 78.35 50 0.7835 39.18 200 0.7835 156.71 200 0.7835 156.71 50 0.7835 39.18 50 0.7835 39.18 100 0.7835 78.35 50 0.7835 39.18 50 0.7835 39.18 210 0.7835 164.54 50 0.7835 39.18 6 50 0.7462 37.31 20 0.7462 14.92 300 0.7462 223.86 300 0.7462 223.86 20 0.7462 14.92 10 0.7462 7.46 300 0.7462 223.86 150 0.7462 111.93 10 0.7462 7.46 210 0.7462 156.71 150 0.7462 111.93 7 40 0.7107 28.43 10 0.7107 7.11 400 0.7107 284.27 400 0.7107 284.27 20 0.7107 14.21 10 0.7107 7.11 500 0.7107 355.34 250 0.7107 177.67 10 0.7107 7.11 210 0.7107 149.24 250 0.7107 177.67 8 30 0.6768 20.31 10 0.6768 6.77 500 0.6768 338.42 500 0.6768 338.42 10 0.6768 6.77 10 0.6768 6.77 500 0.6768 338.42 350 0.6768 236.89 10 0.6768 6.77 210 0.6768 142.14 350 0.6768 236.89 9 20 0.6446 12.89 5 0.6446 3.22 500 0.6446 322.30 500 0.6446 322.30 10 0.6446 6.45 10 0.6446 6.45 500 0.6446 322.30 350 0.6446 225.61 0 0.6446 0.00 210 0.6446 135.37 350 0.6446 225.61 10 10 0.6139 6.14 5 0.6139 3.07 100 0.6139 61.39 100 0.6139 61.39 10 0.6139 6.14 10 0.6139 6.14 500 0.6139 306.96 250 0.6139 153.48 0 0.6139 0.00 210 0.6139 128.92 300 0.6139 184.17 446.12 432.20 581.58 540.08 249.20 448.32 793.89 486.93 226.58 621.56 518.06 Rank 8 9 3 4 10 7 1 6 11 2 5

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