A firm utilizes a strategy of capital rationing, which is currently $375,000 and

Question

A firm utilizes a strategy of capital rationing, which is currently $375,000 and is considering the following two projects: Project A has a cost of $335,000 and the following cash flows: year 1 $140,000; year 2 $150,000; and year 3 $100,000. Project B has a cost of $365,000 and the following cash flows: year 1 $220,000; year 2 $110,000; and year 3 $150,000. Using a 6% cost of capital, which decision should the financial manager make?

Select project A.

Select project B.

Do not select either project.

Select both projects.

Explanation / Answer

Answer:

Calculation of net cash inflow from both project Particular Present value of $1 @ 6% Project A Project B Cash Inflow Present value of Cash Inflow Cash Inflow Present value of Cash Inflow ($) ($) ($) ($) Year 1 0.943        1,40,000            1,32,020        2,20,000          2,07,460 Year 2 0.89        1,50,000            1,33,500        1,10,000             97,900 Year 3 0.84        1,00,000                84,000        1,50,000          1,26,000 Total            3,49,520          4,31,360 Less: Initial Investment            3,35,000          3,65,000 Net Present value                14,520             66,360 * Firm strategy of total capital rationing is $375000. It can not opt both project , firm can consider only one project from above two. * Since Net present value of project B is higher i.e.$ 66,360 ,so Firm should opt project B

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