Question

Capital rationing: NPV approach A firm with a 13% cost of capital must select the optimal group of projects from those shown in the following table, given its capital budget of $1 million.

Project	Initial investment	NPV at 13% cost of capital
A	−$300,000	$ 84,000
B	−200,000	10,000
C	−100,000	25,000
D	−900,000	90,000
E	−500,000	70,000
F	−100,000	50,000
G	−800,000	160,000

1. Calculate the present value of cash inflows associated with each project.

2. Select the optimal group of projects, keeping in mind that unused funds are

Answer 1

1.
Present value of cash inflows=NPV+Initial Investment

A=84000+300000=384000

B=10000+200000=210000

C=25000+100000=125000

D=90000+900000=990000

E=70000+500000=570000

F=50000+100000=150000

G=160000+800000=960000

2.
Profitability Index PI=1+NPV/Initial Investment

A
=1+84000/300000=1.28
B
=1+10000/200000=1.05
C
=1+25000/100000=1.25
D
=1+90000/900000=1.1
E
=1+70000/500000=1.14
F
=1+50000/100000=1.5
G
=1+160000/800000=1.2

Start with the highest PI and lower till the budget is reached

Accept Project F,A,C,E