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 Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	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.

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