Question

P12–19 Capital rationing: IRR and NPV approaches Valley Corporation is attempting to select the best of a group of independent projects competing for the firm’s fixed capital budget of $4.5 million. The firm recognizes that any unused portion of this budget will earn less than its 15% cost of capital, thereby resulting in a present value of inflows that is less than the initial investment. The firm has summarized, in the following table, the key data for selecting the best group of projects.

Project	Initial investment	IRR	Present value of inflows at 15%
A	−$5,000,000	17%	$5,400,000
B	−800,000	18	1,100,000
C	−2,000,000	19	2,300,000
D	−1,500,000	16	1,600,000
E	−800,000	22	900,000
F	−2,500,000	23	3,000,000
G	−1,200,000	20	1,300,000

1. Use the internal rate of return (IRR) approach to select the best group of projects.
2. Use the net present value (NPV) approach to select the best group of projects.
3. Compare, contrast, and discuss your findings in parts a and b.
4. Which projects should the firm implement? Why?

Answer 1

a.Using IRR, the projects should be chosen with the highest IRR

i.e. Projects F,E and G

Cost = 2,500,000+1,200,000+800,000 = 4.5 million

b.Using NPV, the projects selected should be those with highest NPVs.

NPV = Present value of cash inflows – Initial Investment

i.e. Projects F, B and G or F,C

Total Cost = 2,500,000+2,000,000 = 4.5 million

Note: project A cannot be chosen since its cost is more than the budget

c.

	a	b
Projects chosen	F,E,G	F,C/F,B,G
Combined NPV	700,000	800,000/900,000

Hence, the firm should implement projects based on NPV because it will provide higher income

i..e Projects F, B and G