Project Free Cash Flows (dollars in thousands)

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 $ 2,200 $ 1,200 $ (350)
2 330 334 200 280 900 (60)
3 330 165 350 280 300 60
4 330 395 280 90 350
5 330 432 280 70 700
6 330 440 280 1,200
7 330 442 280 2,250
8 1,000 444 280
9 446 280
10 448 280
11 450 280
12 451 280
13 451 280
14 452 280
15 10,000 (2,000) 280

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 investment $ 1,310 $ 165 $ 8,000 $
1,561 $ 2,200 $ 200 $ 560 $ 2,150

Indicates year in which payback is accomplished
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
from the ranking obtained by simple inspection of the cash flows?
4. What kinds of real investment projects have cash flows similar to those in Exhibit 1?

1. Although we can rank the projects by simply inspecting the cash flows, it is still not a
good measure to rank them.
The Ranking by simply inspecting the cash flows:
Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 3 5 8 4 1 7 6 2
Cash Flows 10,000 4,200 4,150 3,561 3,310 2,560 2,200 2,165

2. It would be better and more accurate if we used quantitative methods like Net Present
Value, Payback Period, Discounted Payback Period, Internal Rate of Return, Average
Accounting Return, or Profitability Index.
a. Net Present Value:

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 3 4 8 7 5 1 6 2
NPV 393.92 228.22 182.98 165.04 129.70 73.09 0.00 -85.45

b. Payback Period:

Project 1:
Years cumulative
0 -2000
1 -1670
2 -1340
3 -1010
4 -680
5 -350
6 -20
7 310

Payback period = 6 + 20/330 = 6.06 years

Project 2:
Years cumulative
0 -2000
1 -334
2 0
3

Payback period = 2 years

Project 3:
Payback period = 15 years
Project 4:
Years cumulative
0 -2000
1 -1840
2 -1640
3 -1290
4 -895
5 -463
6 -23
7 419

Payback period = 6 + 23/442 = 6.05 years

Project 5:
Years cumulative
0 -2000
1 -1720
2 -1440
3 -1160
4 -880
5 -600
6 -320
7 -40
8 240

Payback period = 7 + 40/280= 7.14 years

Project 6:
Years cumulative
0 -2000
1 200
Payback period = 0.91 years
Project 7:
Years cumulative
0 -2000
1 -800
2 100

Payback period = 1+ 800/900= 1.88 years

Project 8:
Years cumulative
0 -2000
1 -2350
2 -2410
3 -2350
4 -2000
5 -1300
6 -100
7 2150

Payback period = 6+ 100/ 2250= 6.04 years

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 6 7 2 8 4 1 5 3
Payback Period 0.91 1.88 2.00 6.04 6.05 6.06 7.14 15

c. Discounted Payback Period:

Project 1:
Years PV of CF cumulative
0 -2000 -2000
1 330/(1.10)=300 -1700
2 330/(1.10)^2=272.7 -1427.3
3 330/(1.10)^3=247.93 -1179.37
4 330/(1.10)^4= 225.3 -954.07
5 330/(1.10)^5=204.90 -749.17
6 330/(1.10)^6= 186.2 -562.9
7 330/(1.10)^7= 169.34 -393.46
8 1000/(1.10)^8=466.50 73.04

Discounted payback period = 7+ 393.46/466.50= 7.84 years

Project2:
Years PV of CF cumulative
0 -2000 -2000
1 1514.54 -485.46
2 276.03 -209.43
3 123.96 -85.47
Project 3:
We do not use this method for this project since there is only one cash flow that occurs in
year 15.

Project4:
Years PV of CF cumulative
0 -2000 -2000
1 145.45 -1854.55
2 165.28 -1689.27
3 262.90 -1426.37
4 269.79 -1156.58
5 268.23 -888.35
6 248.36 -639.99
7 226.81 -413.18
8 207.12 -206.06
9 189.14 -16.92
10 172.72 155.8
Discounted payback period= 9+ 16.92/172.72= 9.09 years
Project5:
Years PV of CF cumulative
0 -2000 -2000
1 254.54 -1745.46
2 231.40 -1514.06
3 210.36 -1303.7
4 191.24 -1112.46
5 173.85 -938.61
6 158.05 -780.56
7 143.68 -636.88
8 130.62 -506.26
9 118.74 -387.52
10 107.95 -279.57
11 98.13 -181.44
12 89.21 -92.23
13 81.10 -11.13
14 73.73 62.6

Discounted payback period= 13 + 11.13/73.73 =13.15 years

Project6:
Years PV of CF cumulative
0 -2000 -2000
1 2000 0
Discounted payback period= 1 year
Project7:
Years PV of CF cumulative
0 -2000 -2000
1 1090.9 -909.1
2 743.80 -165.3
3 225.39 60.09

Discounted payback period= 2 + 165.3/225.39= 2.7 years

Project8:
Years PV of CF cumulative
0 -2000 -2000
1 -318.18 -2318.18
2 -49.58 -2367.76
3 45.07 -2322.69
4 239.05 -2083.64
5 434.6 -1649.04
6 677.36 -971.68
7 1154.6 182.92

Discounted payback period= 6 + 971.68/1154.6= 6.84 years

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 6 7 8 1 4 5 2 3
Discounted Payback Period 1.00 2.70 6.84 7.84 9.09 13.15 Negative Cash
Flow NONE

d. Average Accounting Return:
We assumed that there is not residual value to the investment.
Project 1:
Average Net Income: ((330*7)+1000)/8=413.75
Average Investment: (2000+0)/2=1000
AAR = 413.75/1000= 41.38%
Project 2:
Average Net Income: (1666+334+165)/3=721.667
Average Investment: (2000+0)/2=1000
AAR = 721.667/1000= 72.17%
Project 3:
Average Net Income: ((0*14)+10000)/15=666.667
Average Investment: (2000+0)/2=1000
AAR = 666.667/1000= 66.67%
Project 4:
Average Net Income:
(160+200+350+395+432+440+442+444+446+448+450+451+451+452+(-2000))/15=237.4
Average Investment: (2000+0)/2=1000
AAR = 237.4/1000= 23.74%
Project 5:
Average Net Income: (280*15)/15=280
Average Investment: (2000+0)/2=1000
AAR = 280/1000= 28%
Project 6:
Average Net Income: (2200)/1=2200
Average Investment: (2000+0)/2=1000
AAR = 2200/1000= 220%
Project 7:
Average Net Income: (1200+900+300+90+70)/5=512
Average Investment: (2000+0)/2=1000
AAR = 512/1000= 51.2%
Project 8:
Average Net Income: ((-350)+(-60)+60+350+700+1200+2250)/7=592.86
Average Investment: (2000+0)/2=1000
AAR = 592.86/1000= 59.29%
Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 6 2 3 8 7 1 5 4
Average Accounting Return 220% 72.17% 66.67% 59.29% 51.2% 41.38%
28% 23.74%

e. Internal Rate of Return:
Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 7 4 8 3 5 1 6 2
Internal Rate of Return 15.25 12.33 11.41 11.33 11.12 10.87 10 6.31

f. Cross Over Rate:
Will be used only on project 7 and 8 since they are the only mutually exclusive projects.
7 8 8-7
(2,000.00) (2,000.00) 0.00
1,200.00 (350.00) (1,550.00)
900.00 (60.00) (960.00)
300.00 60.00 (240.00) IRR=10%
90.00 350.00 260.00
70.00 700.00 630.00
0.00 1,200.00 1,200.00
0.00 2,250.00 2,250.00
NPV NPV
165.04 182.98 ? Higher NPV

Rank 1st 2nd
Project 8 7
IRR 10% 10%
NPV 182.98 165.04

g. Profitability Index:
PI 1=2,073.09/2,000.00=1.04
PI 2=1,914.55/2,000.00=0.96
PI 3=2,393.92/2,000.00=1.20
PI 4=2,228.22/2,000.00=1.11
PI 5=2,129.70/2,000.00=1.06
PI 6=2,000.00/2,000.00=1.00
PI 7=2,165.04/2,000.00=1.08
PI 8=2,182.98/2,000.00=1.09
Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 3 4 8 7 5 1 6 2
Profitability Index 1.20 1.11 1.09 1.08 1.06 1.04 1.00 0.96

3. Ranking:
Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 3 5 8 4 1 7 6 2
Cash Flows 10,000 4,200 4,150 3,561 3,310 2,560 2,200 2,165
All the projects will be undertaken except for project 7 since it is mutually exclusive with
project 8.

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 3 4 8 7 5 1 6 2
NPV 393.92 228.22 182.98 165.04 129.70 73.09 0.00 -85.45
All the projects will be undertaken except for project 7 since it is mutually exclusive with
project 8, and project 6 and 2 will not be undertaken since they have 0 and negative value.

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 6 7 2 8 4 1 5 3
Payback Period 0.91 1.88 2.00 6.04 6.05 6.06 7.14 15
All the projects will be undertaken except for project 8 since it is mutually exclusive with
project 7, and also project 3 might not be taken since it has the highest payback period, 15
years, which is almost the double of the 7th best payback period.

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 6 7 8 1 4 5 2 3
Discounted Payback Period 1.00 2.70 6.84 7.84 9.09 13.15 Negative Cash
Flow NONE
All the projects will be undertaken except for project 8 since it is mutually exclusive with
project 7, and project 2 and 3 will not be undertaken since project 2 will not pay the whole
initial investment, and we also couldnt use the discounted payback period for project 3 since
it has only one cash flow at year 15.

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 6 2 3 8 7 1 5 4
Average Accounting Return 220% 72.17% 66.67% 59.29% 51.2% 41.38%
28% 23.74%
All the projects will be undertaken except for project 7 since it is mutually exclusive with
project 8.

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 7 4 8 3 5 1 6 2
Internal Rate of Return 15.25 12.33 11.41 11.33 11.12 10.87 10 6.31
All the projects will be undertaken except for project 8 since it is mutually exclusive with
project 7, and project 6 and 2 will not be undertaken since they have IRR that is less than the
10%, the discount rate. Project 1 also might not be taken since certain officers of the
company have recently asserted that the discount rate should be much higher.


Rank 1st 2nd
Project 8 7
IRR 10% 10%
NPV 182.98 165.04
Since these two projects are mutually exclusive and have the IRR (10%), Project 8 will be
chosen because it has higher NPV.

Rank 1st 2nd 3rd 4th 5th 6th 7th 8th
Project 3 4 8 7 5 1 6 2
Profitability Index 1.20 1.11 1.09 1.08 1.06 1.04 1.00 0.96
All the projects will be undertaken except for project 7 since it is mutually exclusive with
project 8, and project 6 and 2 will not be undertaken since they have PIs equal to 1 and 0.96,
because they are not greater than 1.

Comparing the quantitative methods, we noticed that project 3 scored 1st three times
using simple inspections of cash flows, NPV, and PI. Project 6 as well scored 1st three times
using payback period, discounted payback period, and AAR. Project 7 however, scored 1st
only through using the IRR method. Looking on the last ranked projects, project 2 has scored
last 4 times using simple inspections of cash flows, NPV, IRR, and PI, while project 3 scored
last two times using payback period and discounted payback period, and project 4 scored last
once using the AAR method.

NPV is considered the best approach since it:
i. Uses Cash Flows.
ii. Uses all the Cash Flows of the project.
iii. And discounts the Cash Flows properly.
And through using the NPV approach, Project 3 got the highest NPV, 393.92, and then comes
4, 8, 5 and 1.


4.
Project 1 Bonds
Project 2 Machine Depreciation
Project 3 Pure Discount Bond (Zero Coupon Bond)
Project 4 Recycling Factory that incur Environmental costs
Project 5 Car Loan
Project 6 Newly Issued Stock
Project 7 Machine Depreciation (Similar to Project2)
Project 8 New Business