Ranking Of Investment Projects Based On Cash Flows And Net Present Value (NPV)
Ranking of Projects based on Cash Flows
Yes the projects can be ranked by simply inspecting the cash flows. Below is the table of raking:
|
Project number: |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
|
Year |
|
|
|
|
|
|
|
|
0 |
-5,000 |
-10,000 |
-15,000 |
-25,000 |
-25,000 |
-30,000 |
-35,000 |
|
1 |
1,000 |
1,000 |
1,700 |
1,000 |
11,000 |
-3,000 |
-9,000 |
|
2 |
1,000 |
2,000 |
1,700 |
1,200 |
10,000 |
10,000 |
-3,000 |
|
3 |
1,000 |
2,000 |
1,700 |
3,000 |
9,000 |
9,000 |
6,000 |
|
4 |
800 |
3,000 |
1,700 |
4,000 |
8,000 |
6,000 |
6,000 |
|
5 |
800 |
3,000 |
1,700 |
5,000 |
7,000 |
6,000 |
8,000 |
|
6 |
700 |
4,000 |
1,700 |
6,000 |
6,000 |
6,000 |
12,000 |
|
7 |
600 |
4,000 |
1,700 |
7,000 |
5,000 |
4,500 |
12,000 |
|
8 |
600 |
2,000 |
1,700 |
8,000 |
4,000 |
4,500 |
14,000 |
|
9 |
500 |
2,000 |
1,700 |
9,000 |
3,000 |
3,000 |
14,000 |
|
10 |
500 |
2,000 |
1,700 |
11,000 |
-5,000 |
3,000 |
14,000 |
|
Sum of cash-flow benefits |
7,500 |
25,000 |
17,000 |
55,200 |
58,000 |
49,000 |
74,000 |
|
Excess of cash flow over initial investment |
2,500 |
15,000 |
2,000 |
30,200 |
33,000 |
19,000 |
39,000 |
|
Ranking |
6 |
5 |
7 |
3 |
2 |
4 |
1 |
In the above table we have simply ranked the project based on the net cash flows. The net cash flows are calculated by netting off the cash inflows and outflows. Therefore, based o the same, project 7 is ranked number 1, since it has the highest cash flows. (Peterson & Fabozzi, 2012)
There are a lot of quantitative methods which can be used in order to choose the best available investment options. We have used the net present value approach, internal rate of return and pay-back period, in order to rank the projects. (Bierman & Smidt, 2010)
Net Present Value
Net present value is the quantitative tool which helps the investor calculates the cash flow from the project. The cash flows which are calculated under this method are then discounted using the appropriate discounting rate. This helps to calculate the present value of the benefits which are expected to generate from a given project. (Shapiro, 2007)
|
Project number: |
PV Factor @ 9% |
PV of CF of project 1 |
PV of CF of project 2 |
PV of CF of project 3 |
PV of CF of project 4 |
PV of CF of project 5 |
PV of CF of project 6 |
PV of CF of project 7 |
|
Year |
|
|
|
|
|
|
|
|
|
0 |
1 |
-5,000 |
-10,000 |
-15,000 |
-25,000 |
-25,000 |
-30,000 |
-35,000 |
|
1 |
0.9174311927 |
917 |
917 |
1,560 |
917 |
10,092 |
-2,752 |
-8,257 |
|
2 |
0.8416799933 |
842 |
1,683 |
1,431 |
1,010 |
8,417 |
8,417 |
-2,525 |
|
3 |
0.7721834801 |
772 |
1,544 |
1,313 |
2,317 |
6,950 |
6,950 |
4,633 |
|
4 |
0.7084252111 |
567 |
2,125 |
1,204 |
2,834 |
5,667 |
4,251 |
4,251 |
|
5 |
0.6499313863 |
520 |
1,950 |
1,105 |
3,250 |
4,550 |
3,900 |
5,199 |
|
6 |
0.5962673269 |
417 |
2,385 |
1,014 |
3,578 |
3,578 |
3,578 |
7,155 |
|
7 |
0.5470342448 |
328 |
2,188 |
930 |
3,829 |
2,735 |
2,462 |
6,564 |
|
8 |
0.5018662797 |
301 |
1,004 |
853 |
4,015 |
2,007 |
2,258 |
7,026 |
|
9 |
0.4604277795 |
230 |
921 |
783 |
4,144 |
1,381 |
1,381 |
6,446 |
|
10 |
0.4224108069 |
211 |
845 |
718 |
4,647 |
-2,112 |
1,267 |
5,914 |
|
Sum of cash-flow benefits |
|
5,106 |
15,563 |
10,910 |
30,539 |
43,265 |
31,710 |
36,407 |
|
Excess of cash flow over initial investment |
|
106 |
5,563 |
-4,090 |
5,539 |
18,265 |
1,710 |
1,407 |
|
Excess of cash flow over initial investment |
|
6 |
2 |
7 |
3 |
1 |
4 |
5 |
Based on net present value calculations we see that project 5 is most viable, as it has the highest positive net present value. This indicates that project 5 is likely to earn highest profits to the investors. (Adelaja, 2015)
Internal Rate of Return
Internal rate of return is the capital budgeting tool which helps us to calculate the actual percentage of return from a given project. Under this tool the cash flows and cash outflows are equated. Then using the process of interpolation the hidden rate of interest is calculated. The project with the highest IRR is considered as the most viable project. (Seitz & Ellison, 2009)
|
Project number: |
0 |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
9 |
10 |
|
1 |
-5,000 |
1,000 |
1,000 |
1,000 |
800 |
800 |
700 |
600 |
600 |
500 |
500 |
|
PV factor @ 9.55% |
1.000000 |
0.912825 |
0.833250 |
0.760611 |
0.694305 |
0.633779 |
0.578530 |
0.528097 |
0.482060 |
0.440036 |
0.401676 |
|
PV @ 9.55% |
-5,000 |
913 |
833 |
761 |
555 |
507 |
405 |
317 |
289 |
220 |
201 |
|
2 |
-10,000 |
1,000 |
2,000 |
2,000 |
3,000 |
3,000 |
4,000 |
4,000 |
2,000 |
2,000 |
2,000 |
|
PV factor @ 19.13% |
1.000000 |
0.839426 |
0.704636 |
0.591490 |
0.496512 |
0.416785 |
0.349861 |
0.293682 |
0.246524 |
0.206939 |
0.173710 |
|
PV @ 19.13% |
-10,000 |
839 |
1,409 |
1,183 |
1,490 |
1,250 |
1,399 |
1,175 |
493 |
414 |
347 |
|
3 |
-15,000 |
1,700 |
1,700 |
1,700 |
1,700 |
1,700 |
1,700 |
1,700 |
1,700 |
1,700 |
1,700 |
|
PV factor @ 2.34% |
1.000000 |
0.977116 |
0.954756 |
0.932907 |
0.911558 |
0.890698 |
0.870315 |
0.850399 |
0.830938 |
0.811923 |
0.793343 |
|
PV @ 2.34% |
-15,000 |
1,661 |
1,623 |
1,586 |
1,550 |
1,514 |
1,480 |
1,446 |
1,413 |
1,380 |
1,349 |
|
4 |
-25,000 |
1,000 |
1,200 |
3,000 |
4,000 |
5,000 |
6,000 |
7,000 |
8,000 |
9,000 |
11,000 |
|
PV factor @ 12.41% |
1.000000 |
0.889624 |
0.791431 |
0.704077 |
0.626364 |
0.557228 |
0.495724 |
0.441008 |
0.392331 |
0.349028 |
0.310503 |
|
PV @ 12.41% |
-25,000 |
890 |
950 |
2,112 |
2,505 |
2,786 |
2,974 |
3,087 |
3,139 |
3,141 |
3,416 |
|
5 |
-25,000 |
11,000 |
10,000 |
9,000 |
8,000 |
7,000 |
6,000 |
5,000 |
4,000 |
3,000 |
-5,000 |
|
PV factor @ 31.18% |
1.000000 |
0.762340 |
0.581163 |
0.443044 |
0.337750 |
0.257481 |
0.196288 |
0.149638 |
0.114075 |
0.086964 |
0.066296 |
|
PV @ 31.18% |
-25,000 |
8,386 |
5,812 |
3,987 |
2,702 |
1,802 |
1,178 |
748 |
456 |
261 |
-331 |
|
6 |
-30,000 |
-3,000 |
10,000 |
9,000 |
6,000 |
6,000 |
6,000 |
4,500 |
4,500 |
3,000 |
3,000 |
|
PV factor @ 10.27% |
1.000000 |
0.906906 |
0.822479 |
0.745911 |
0.676471 |
0.613496 |
0.556383 |
0.504587 |
0.457613 |
0.415012 |
0.376377 |
|
PV @ 10.27% |
-30,000 |
-2,721 |
8,225 |
6,713 |
4,059 |
3,681 |
3,338 |
2,271 |
2,059 |
1,245 |
1,129 |
|
7 |
-35,000 |
-9,000 |
-3,000 |
6,000 |
6,000 |
8,000 |
12,000 |
12,000 |
14,000 |
14,000 |
14,000 |
|
PV factor @ 9.51% |
1.000000 |
0.913142 |
0.833828 |
0.761403 |
0.695269 |
0.634880 |
0.579735 |
0.529381 |
0.483400 |
0.441412 |
0.403072 |
|
PV @ 9.51% |
-35,000 |
-8,218 |
-2,501 |
4,568 |
4,172 |
5,079 |
6,957 |
6,353 |
6,768 |
6,180 |
5,643 |
Following are the projects laid down with IRR and Ranks:
|
Project |
IRR |
Rank |
|
1 |
10 |
5 |
|
2 |
19 |
2 |
|
3 |
2 |
7 |
|
4 |
12 |
3 |
|
5 |
31 |
1 |
|
6 |
10 |
4 |
|
7 |
10 |
6 |
Therefore based on above calculations we can say that project 5 is the most viable project, with highest IRR of 31%.
Pay-back period refers to the time period in which the amount invested is recovered by the investor(Menifield, 2014). Lower the period in which the amount is recovered better it is for the investor. Following is the cumulative cash flows table for the projects which will help us calculate the pay-back period:
|
Project number: |
1 |
Cumulative Cash Flows |
2 |
Cumulative Cash Flows |
3 |
Cumulative Cash Flows |
4 |
Cumulative Cash Flows |
5 |
Cumulative Cash Flows |
6 |
Cumulative Cash Flows |
7 |
Cumulative Cash Flows |
|
0 |
-5,000 |
-5,000 |
-10,000 |
-10,000 |
-15,000 |
-15,000 |
-25,000 |
-25,000 |
-25,000 |
-25,000 |
-30,000 |
-30,000 |
-35,000 |
-35,000 |
|
1 |
1,000 |
-4,000 |
1,000 |
-9,000 |
1,700 |
-13,300 |
1,000 |
-24,000 |
11,000 |
-14,000 |
-3,000 |
-33,000 |
-9,000 |
-44,000 |
|
2 |
1,000 |
-3,000 |
2,000 |
-7,000 |
1,700 |
-11,600 |
1,200 |
-22,800 |
10,000 |
-4,000 |
10,000 |
-23,000 |
-3,000 |
-47,000 |
|
3 |
1,000 |
-2,000 |
2,000 |
-5,000 |
1,700 |
-9,900 |
3,000 |
-19,800 |
9,000 |
5,000 |
9,000 |
-14,000 |
6,000 |
-41,000 |
|
4 |
800 |
-1,200 |
3,000 |
-2,000 |
1,700 |
-8,200 |
4,000 |
-15,800 |
8,000 |
13,000 |
6,000 |
-8,000 |
6,000 |
-35,000 |
|
5 |
800 |
-400 |
3,000 |
1,000 |
1,700 |
-6,500 |
5,000 |
-10,800 |
7,000 |
20,000 |
6,000 |
-2,000 |
8,000 |
-27,000 |
|
6 |
700 |
300 |
4,000 |
5,000 |
1,700 |
-4,800 |
6,000 |
-4,800 |
6,000 |
26,000 |
6,000 |
4,000 |
12,000 |
-15,000 |
|
7 |
600 |
900 |
4,000 |
9,000 |
1,700 |
-3,100 |
7,000 |
2,200 |
5,000 |
31,000 |
4,500 |
8,500 |
12,000 |
-3,000 |
|
8 |
600 |
1,500 |
2,000 |
11,000 |
1,700 |
-1,400 |
8,000 |
10,200 |
4,000 |
35,000 |
4,500 |
13,000 |
14,000 |
11,000 |
|
9 |
500 |
2,000 |
2,000 |
13,000 |
1,700 |
300 |
9,000 |
19,200 |
3,000 |
38,000 |
3,000 |
16,000 |
14,000 |
25,000 |
|
10 |
500 |
2,500 |
2,000 |
15,000 |
1,700 |
2,000 |
11,000 |
30,200 |
-5,000 |
33,000 |
3,000 |
19,000 |
14,000 |
39,000 |
Following is the table of payback period:
|
Project |
Pay-back Period |
Rank |
|
1 |
5.57 |
3 |
|
2 |
4.67 |
2 |
|
3 |
8.82 |
7 |
|
4 |
6.69 |
5 |
|
5 |
2.40 |
1 |
|
6 |
6.33 |
4 |
|
7 |
7.21 |
6 |
Therefore, based on the calculations, project 5 is the most viable project, as it has the lowest pay-back period of 2.40 years.
Following is the table, which contains ranking of all the projects based on all the quantitative methods above:
|
Table of Ranking |
||||
|
Project number: |
Based on Cash Flows |
Based on NPV |
Based on IRR |
Based on Pay Back |
|
1 |
6 |
6 |
5 |
3 |
|
2 |
5 |
2 |
2 |
2 |
|
3 |
7 |
7 |
7 |
7 |
|
4 |
3 |
3 |
3 |
5 |
|
5 |
2 |
1 |
1 |
1 |
|
6 |
4 |
4 |
4 |
4 |
|
7 |
1 |
5 |
6 |
6 |
Therefore from the above table we can see that based on cash flows project number 7 seems most viable (Rivenbark, Vogt, & Marlowe, 2009). But as we proceed with our quantitative methods we find that project 5 is the most viable under all other quantitative methods. This can be explained logically. In the capital budgeting decision the sum of cash flows do not matter individually. The timing of the cash flow, the required rate of return, the frequency of return, all aspects together help to take a proper decision. Under the NPV, IRR and pay-back methods of evaluation the cash flows are discounted and their present values are used in order to determine the viability of a project. This helps us calculate the benefit generated from each project in terms of value of today. This results in better comparability of various options. Hence helps us to take the correct decision. Therefore, this is the reason the ranking are not same under the methods. (Dayananda, Irons, Harrison, Herbohn, & Rowland, 2008)
Based on our evaluation above we see that project 5, 4 and 6 are the top most projects with highest ranking under all the quantitative methods. But, since projects 4 and 5 are mutually exclusive; we can select only one form these two. Since project 5 is has better performance than project 4, we opt of project 5. Also, now we need to select the next best available option, which is project number 2. Therefore the three best projects that the company should accept are project number 5, 6 and 2.
References
Adelaja, T. (2015). Capital Budgeting: Investment Appraisal Techniques Under Certainty. Chicago: CreateSpace Independent Publishing Platform .
Bierman, H., & Smidt, S. (2010). The Capital Budgeting Decision. Boston: Routledge.
Dayananda, D., Irons, R., Harrison, S., Herbohn, J., & Rowland, P. (2008). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press.
Menifield, C. E. (2014). The Basics of Public Budgeting and Financial Management: A Handbook for Academics and Practitioners. Lanham, Md.: University Press of America.
Peterson, P. P., & Fabozzi, F. J. (2012). Capital Budgeting. New York, NY: Wiley.
Rivenbark, W. C., Vogt, J., & Marlowe, J. (2009). Capital Budgeting and Finance: A Guide for Local Governments. Washington, D.C.: ICMA Press.
Seitz, N., & Ellison, M. (2009). Capital Budgeting and Long-Term Financing Decisions. New York: Thomson Learning.
Shapiro, A. C. (2007). Capital Budgeting and Investment Analysis. New Jersey: Wiley.