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The Investment Detective
Objective of the case:
This case presents the cash flows of eight unidentified investments, all of equal initial investment size. Your task is to rank the projects. The first objective of the case is to examine critically the principal capital-budgeting criteria.
A second objective is to consider the problem that arises when net present value (NPV) and internal rate of return (IRR) disagree as to the ranking of two mutually exclusive projects.
Finally, the case is a vehicle for introducing the problem created by attempting to rank projects of unequal life and the solution to that difficulty—the equivalent-annuity criterion.
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Assignments:
Fill the yellow part of the excel sheet. And then answer the following questions:
1) Which of the two projects, 7 or 8, is more attractive?
a. How sensitive is our ranking to the use of high discount rates?
b. Why do NPV and IRR disagree?
2) What rank should we assign to each project?
a. Why do payback and NPV not agree completely?
b. Why do average return on investment and NPV not agree completely?
c. Which criterion is best?
3) Are those projects comparable based on NPV?
a. Because the projects have different lives, are we really measuring the “net present” value of the short-lived projects?
4) What is the equivalent-annuity method and when is it called for in project comparisons?
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The key points ABOUT capital budget should be the following:
- IRR: Possibly incorrect opportunity cost assumption. Violates value additivity. Multiple IRRs are possible.
- NPV: May be difficult to explain.
- ROI: Often computed on profits, not cash flow. Ignores time profile of flows and the time value of money.
- Payback: Ignores time value of money, although it is a proxy for the liquidity or duration of an investment and is sometimes used in conjunction with NPV.
The Investment Detective
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