Investment

The essence of capital budgeting and resource allocation is a search for good investments

in which to place the firm's capital. The process can be simple when viewed in purely mechanical

terms, but a number of subtle issues can obscure the best investment choices. The

capital-budgeting analyst is necessarily, therefore, a detective who must winnow good evidence

from bad. Much of the challenge is knowing what quantitative analysis to generate

in the first place.

Suppose you are a new capital-budgeting analyst for a company considering investments

in the eight projects listed in Exhibit 1. The chief financial officer of your company

has asked you to rank the projects and recommend the "four best" that the company

should accept.

In this assignment, only the quantitative considerations are relevant. No other project

characteristics are deciding factors in the selection, except that management has determined

that projects 7 and 8 are mutually exclusive.

All the projects require the same initial investment, $2 million. Moreover, all are believed

to be of the same risk class. The weighted-average cost of capital of the firm has

never been estimated. In the past, analysts have simply assumed that 10 percent was an appropriate

discount rate (although certain officers of the company have recently asserted that

the