Question

Suppose you are a financial manager and you have the following investment opportunities:

Project	Investment (in $1,000)	NPV (in $1,000)
1	500	100
2	200	-4
3	125	-7
4	50	50
5	250	60

Which of the following projects should you pursue if you have only $700,000 allocated for capital expenditures? How much does the budget limit cost the company in terms of forgone NPV? The opportunity cost of capital for each project is 15%.

Answer 1

Out of the 5 projects that can be pursued, only project 1 , 4 and 5 have positive net present value. Project 2 and 3 have negative net present value and hence they will not be pursued.

Project 1 has an investment of $ 500,000 and if investment is made in project 1, then we are left with only $ 200,000 to make investments into other projects. We cannot make investment into project 5 because it requires an investment of $ 250,000 . Hence the only investment we can make other than project 1 is project 4.

The total NPV from selecting project 1 and project 4 equals $ 150,000.

Due to limited budget, the cost to the company in terms of foregone NPV equals $ 60,000.

If the firm did not have limited budget, it could have pursued project 5 as well which would have resulted in total NPV of $ 210,000.