The Investment Detective

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The Investment Detective

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 challenges is knowing what quantitative analysis to generate in the first place.

Supposed 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
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Project 2 and 6 are similar to an actual venture capital project where bulk of the cash inflow occurs at the end while some of the inflow is at the beginning.

Project 3 is similar to a zero coupon bond where you purchase the bond at a specific price and you receive an big cash outflow at the end of the maturity period.

Project 4,7 and 8 are like an investment in a machinery, which generates positive cash for you for a certain period of time. After a while, you can sell that off and receive some more cash. You might have some additional cash outflows initially to get the machinery going (training etc.).

Project 5 is similar to an annuity.

Part II

The company has the following capital structure:

|Account |$ |Costs before tax |
|Long-term Debt |2,000,000 |10% |
|Preferred Stock |500,000 |14% |
|Common Stock |2,500,000 |16% |

1. Calculate the weighted average cost of
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