Financial Management and Policy

The search for the better capital projects for investing firm’s capital is the essence of resource allocation and capital budgeting. The process of choosing a capital investment, which seems simple, have many minor but important challenges which can create issues in selecting the best investment choice. Hence, the capital budgeting analyst needs to work more as a detective who must carefully choose the investment project by rejecting ones with bad expected performance. In this detection process, an important challenge is to know which quantitative technique of capital budgeting is to use in certain conditions.
Assume that you are a new analyst hired to evaluate the capital budgeting projects of the company which is considering investing in eight projects shown in the Annexure A. The CEO of the company has requested you to inspect the projects and recommend the “four best Project”.

The focus of this project/assignment is quantitative factors hence you should only focus on the quantitative methods useful in helping you choose the best choices, while ignoring all other considerations. Only one more conditional factor is there that project 7 and 8 are mutually exclusive project.
The initial investment for each project is fixed at 2 million dollars. Company discount all projects based on WACC. Further, all the projects are equally risky projects and the company uses only debt and common equity for financing these projects. It can borrow unlimited amounts at an interest rate of rd 7.703% as long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend (D0) was $2.0, its expected constant growth rate is 4%, and its common stock sells for $20. The tax rate is 40%.
Carefully analyze the Annexure A and answer the following questions in detail.
1. Just by observing cashflows, can you rank the projects? Which one seems best choice. List them in the order of selection from 1st to last choice.
2. What are the criteria that you might use in evaluating these projects? Which capital budgeting method seems best choice for you? why?
3. List the ranking you found by using each the evaluation criteria starting from payback period to Modified internal rate of return (use pay back, discounted payback, profitability Index, NPV, IRR, and MIRR based on (Wacc discount rate). How do you interpret the results based on each of six criteria?
4. Analyze the cashflows and think of real-life businesses that can generate similar cashflows. List a few of them?
5. Repeat point number 3 while using the cost of capital of 9.25% and 11% respectively. Does the change in cost of capital have any impact on the ranking of the projects? why?

Annexure A

Reply 1

Fahad Ali Bhutto

The initial investment for each project is fixed at 2 million dollars. Company discount all projects based on WACC. Further, all the projects are equally risky projects and the company uses only debt and common equity for financing these projects. It can borrow unlimited amounts at an interest rate of rd 7.703% as long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend (D0) was $2.0, its expected constant growth rate is 4%, and its common stock sells for $20. The tax rate is 40%.
Carefully analyze the Annexure A and answer the following questions in detail.
1. Just by observing cashflows, can you rank the projects? Which one seems best choice. List them in the order of selection from 1st to last choice.
2. What are the criteria that you might use in evaluating these projects? Which capital budgeting method seems best choice for you? why?
3. List the ranking you found by using each the evaluation criteria starting from payback period to Modified internal rate of return (use pay back, discounted payback, profitability Index, NPV, IRR, and MIRR based on (Wacc discount rate). How do you interpret the results based on each of six criteria?
4. Analyze the cashflows and think of real-life businesses that can generate similar cashflows. List a few of them?
5. Repeat point number 3 while using the cost of capital of 9.25% and 11% respectively. Does the change in cost of capital have any impact on the ranking of the projects? why?