Question 1 (3p) According to King (1975) investment appraisal techniques have a slightly different role in investment decision-making in practice

than what is prescribed in the standard textbook. Describe this discrepancy briefly.

In theory, investment appraisal techniques is usually seen as the most important basis for the investment decision, but in practice only one of many basis for a decision. In fact, these techniques are often more important for the project manager to justify the investment to others, rather as the actual basis for the decision. These techniques might therefore be located in earlier phases of the capital budgeting process.

Question 2 (12p) Two mutually exclusive IT investments, A or B, are evaluated. The discount rate is 5 % and cash flows are expected to be: Year 0 1 2 3 4 Cash flow A -500 125 145 165 505 Cash flow B -425 165 135 125 110

a) Calculate the discounted payback period. If the (predetermined) cut-off period is 3 years, what investment decision should be made? (2p)

No investment!
b) What investment decision should be made based on the Net Present Value (NPV) method? Show your calculations. (3p)

Choose alternative A (NPV309)

c) What investment decision should be made based on the Internal Rate of Return (IRR) if the (predetermined) cut-off percentage is 7%? Show your calculations. (3p)

Choose alternative A (IRR23,58%)

d) Describe two different situations when IRR: 1) would be the preferred method 2) would be problematic as basis for a investment decision. (2p)

1) e.g. when the profitability (percentage) is more important than profit 2) e.g. Unconventional cash flows: A negative cash flow after a positive one. Impossible to calculate IRR or end up with multiple IRRs.
e) Assume two mutually exclusive projects with different life span being evaluated. How can one make a comparison between these projects in a somewhat fair manner (i.e. describe at least one method for coping with this situation)? (2p)

Using a standard formula to discount the perpetuity annuities (Equivalent Annual Cash, EAC) or adjusted net present value (i.e. assume that it is possible to re-invest with same terms in the future to make life span equal).

Question 3 (4p) A company is evaluating three mutually exclusively IT-systems which have the following expected pay-offs (MUSD) in respect to three different economic states (recession, normal and boom): Alternatives 1 2 3 Recession 8 8 7 Normal 9 8 8 Boom 10 8 9

Which alternative will be chosen if you use some of the following criterion: a) Maximin (Pessimist Criterion) (1p)

Choose alternative 1 or 2
b) Maximax (Optimist Criterion) (1p)

Choose alternative 1
c) According to expected (monetary) value criterion if we assume that the probability for Recession is 30%, for Normal is 30%, and for Boom is 40%. (2p)

Alternative 1: EMW= 0,3*8+0,3*9+0,4*10=9,1 Alternative 2: EMW= 0,3*8+0,3*8+0,4*8= 8 Alternative 3: EMW= 0,3*7+0,3*8+0,4*9= 8,1 Choose alternative 1

Question 4 (6p) A company uses the Analytical Hierarchy Process (AHP) to evaluate two (mutually exclusive) computer systems; A and B. They are considering two factors that are important; flexibility and price. The project manager, who sadly have not taken the course "IT investments and procurements", failed to reach further than the second step in this process. Your job is to continue the process until you have reached a basis for decision (i.e. no need to determine consistency ratio). Flexibility Computer system A Computer system B Computer system A 1 1/3 Computer system B 3 1

Price Computer system A Computer system B

Computer system A 1 2

Computer system B 1/2 1

If we assume price is favoured 3 to 1 over flexibility: then we should choose computer system A (0,6458).

Question 5 (4p) Explain the meaning of following two terms, that both are associated with investment decisions, in a concise way (max 5 sentences/term).

a) Cost/Benefit analysis (3p): An evaluation method that consider the net value-added benefits (benefits: e.g. increased productivity, reduced working hours, better customer service, less maintenance work and cost e.g.: adaption, service, or hardware) besides the financial ones. The benefits and costs associated with the investments are "translated" into monetary terms and are discounted using one of the investment appraisal techniques PB, ARR, IRR or NPV. This methods can be used ex ante, during or for ex post evaluation.
b) Risk (1p):

Under this environment some information on the payoffs are available but are presented in a probabilistic fashion or The potential that a decision will lead to a loss (an undesirable outcome).