Question

A company is considering the following investment opportunities: Project A Initial cost = $5,500,000 Expected life = 10 yrs NPV = $340,000 IRR = 20%

Project B Initial cost = $3,000,000 Expected life = 10 yrs NPV = $300,000 IRR = 30%

Project C Initial cost = $2,000,000 Expected life = 10 yrs NPV = $200,000 IRR = 40%

If the company has a WACC of 15% and the company is using capital rationing with a fixed capital budget of $5,500,000, which project(s) should the company pursue? The projects are not mutually exclusive.

Answer 1

Within a fixed capital budget of $ 5,500,000, if the company selects Project A, it will utilize all its budget and will result in NPV of $ 340,000

Further if the company selects project B and project C instead of project A, it will be within the capital budget of $ 5,500,000 and will result in to NPV of

= $ 300,000 + $ 200,000

= $ 500,000

So, it will be better for the company to select projects B and C instead of project A, since it results in to additional NPV of

= $ 500,000 - $ 340,000

= $ 160,000

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