EXECUTIVE SUMMARY

The capital-budgeting analyst is necessarily a detective who must winnow bad evidence from good. The
analyst must know what quantitative analysis to generate in the first place. The essence of capital
budgeting and resource allocation is a search for good investments in which to place the firms capital.
We, as a new capital-budgeting analyst for a company considering investments in eight
projects, must rank the projects and recommend the four best that the company should accept

I. Objectives
We want to rank the projects and recommend the four best that the company
should accept. In this case, only the quantitative considerations are relevant. Also,
management has determined that projects 7 and 8 are mutually exclusive. For the case,
there are some information such as:
All the projects require the same initial investment ($2 million).
All are believed to be of the same risk class.
The firms weighted average cost of capital has never been estimated, but in the past
analyst has simply assumed that 10% was an appropriate discount rate
Furthermore, there are some questions that we will answer to help deepen our analysis.
The questions are:
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?

II. Analysis
The projects free cash flow would be analyzed to know which method is the best. The analysis would
answer the four questions above.
II.1. Simply inspecting the cash flows
We could slightly rank the projects based on the biggest excess of cash flow over initial investment.
Well, that is a start. The next step should be:
a. Discounting back the cash flows and getting the proper NPV for each project.
b. A feasibility analysis for lack of a better term, such as: How accurate were your
projections for future flows? Is the any possible thing that could go wrong?
c. Considering the initial and future outlay necessary to start up and continue
the project in order to get the cash flows. So, actually, we could not rank the projects by
using simple inspection.
II.2. Quantitative ranking methods
Net Present Value (NPV), Payback Period, Profitability Index, and Internal Rate of Return (IRR) are
usually used to help us to know whether sum of the cash flow of a project exceeds expected rate
of return or cost of capital of a company or not. Among those quantitative ranking
methods, NPV is the best because:
a. IRR only gives percentage and ignores the magnitude of the cash flows.
b. Payback Period ignores time value of money and does not consider the cash flows after
payback period.
c. Profitability Index or Benefit-Cost Ratio does not tell you in absolute terms how
profitable an investment is versus all investment options.
 d. NPV considers time value of money and takes care of all cash value till the end of life of
the project. It also considers the magnitude of the cash flows. It reflects the net increase
in the projects wealth.

II.3. Ranking obtained from quantitative ranking methods

We could see that the ranking obtained from each of the four quantitative methods is different with
ranking obtained from simple inspection of the cash flows.

II.4. Identification of cash flows pattern

We could identify the kinds of real investment projects that has similar pattern with cash
flows pattern shown above.
a. Project 1 is Leasing or Partially Amortizing Bond. In this project, cash flows were amortized over
a period of 8 years, the remaining $1000 would be due immediately, in one lump sum, at the
end of those 8 years.
b. Project 2 is Advertising Campaign. In this project, cash flows are bigger at the first year, and then
decreasing steeply at the next year. Moreover, this project has only three years life. This project
has biggest cash flow at the first year because advertising works best on the first year. At
the second year and third year, the satisfaction level of the advertising would be
reduced.
c. Project 3 is Private Equity or Zero-Coupon Bond. In this project, cash inflow is only happened in
one lum sum, at the end of the project.
d. d. Project 4 is Nuclear-power Plant In this project, a firm should pay environmental cost because
the waste would potentially causes pollution. This payment would be a cash flow inflow in
cash flow statement. At the end of the project, the firm will extract the
environmental cost from cash flows statement as payment.
e. Project 5 is Leasing with 0 Terminal Value or Home Mortgage. In this project, cash inflow is
amortized until the end of the project with no Terminal Value.
f. Project 6 is One-year Bond. In this project, the firm would hope to get more funds. Therefore, it
on happens on the first year
g. Project 7 is Mining. This project has almost similar pattern with project 2. In this project, the
biggest cash inflow is at the first year because the firm can get the most mineral at the first
year. At the next year, the firm would have lower resources and make lower cash inflows.
h. Project 8 is Orchard. This project is the inverse of the project 7, where the biggest cash inflows
at almost the end of the project. The firm should wait for the orchards materials grow properly
and can be sold

III. Conclusion and Recommendation

3.1 Conclusion
Based on analysis above, we could conclude that:
1. We could rank the projects by using simple inspection of the cash flows. We should consider time
value of money and also cost of capital for each project.
2. The best tool for ranking the projects is NPV.
3.2 Recommendation
We would recommend that:
1. The decision maker could use knowledge about cash flow pattern in choosing the best project