Can You Rank the Projects Simply by Inspecting the Cash Flows?
Capital Budgeting Concepts
1. Can you rank the projects simply by inspecting the cash flows?
Analyzing the sum and the excess of cash flow can give the business an order of the most profitable investments; however it does not give the full details that are important to determining true profitability. As one can see from the charts, Project Number 3 has the highest sum of cash-flow benefits and excess of cash flow, but the payback is not accomplished until the 15th year. Other Projects may not have a high sum of cash-flow; however the initial payback happens very quickly which proves to be important when making these types of investments. The Net Present Value can not be figured from just inspecting the cash flows nor can any of the other procedures necessary to fully get the scope of the investment. It is important when making investments of this magnitude to evaluate all procedures available to decide upon the best one.
2. What criteria might you use to rank the projects? Which quantitative ranking methods are better? Why?
Several different procedures are available to analyze potential business investments. Some concepts are better than others when it comes to reliability but all provide enough information to get the general scope of the investment. The five procedures that provide useful information are the Net present Value (NPV), the Payback Rule, the Average Accounting Return (AAR), the Internal Rate of Return (IRR), and the Profitability Index (PI). These procedures will help rank the projects from the greatest investment to the worst.
First, the most important concept of evaluating these investments is the NPV. NPV is defined as the difference between an investments market value and its cost. It is only a good investment if it makes money for the company so a positive NPV will be needed. The projects can be ranked from the most positive NPV to the lowest to determine profitability. This quantitative ranking method is the best to use due to its consideration of the time value of money and its more accurate breakdown of value.
Second, the payback rule is how long it takes to recover the initial investment. It is noted on the case study as to which year the investment is recouped and it is easy to rank the projects, however this is not the best procedure to use. This rule does not involve discounting which means that time value of money is disregarded, it fails to consider risk differences, and an accurate cutoff period cannot be picked.
Third, another possible approach is the AAR. This is defined as an investments average net income divided by its average book value. The projects can be ranked according to the excess of AAR compared to the target AAR. Once again, this is a flawed approach because it is not comparable to the returns offered, it ignores