Table 10 -1. Capital Budgeting Choices Refer to Table 10-1. Glen Write owns an e
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Question
Table 10-1. Capital Budgeting Choices
Refer to Table 10-1. Glen Write owns an engineering firm. He asked his employees for suggestions regarding equipment they thought the firm would need during the next year. They suggested the purchase of eight pieces of equipment. Glen calculated the net present value of each recommendation. Glen estimates that he will have no more than $150,000 to invest next year. Based on the projects chosen, how much will he actually invest?
$136,250
$290,500
$145,000
$299,750
BusinessLocation Capital
Investment
Cost in $ Cumulative
Investment
Costs Net
Present
Value 1 25,000 25,000 27,500 2 28,500 53,500 35,000 3 32,500 86,000 35,000 4 32,500 118,500 38,000 5 45,000 163,500 (15,000) 6 54,000 217,500 (10,000) 7 63,250 280,750 92,000 8 73,000 353,750 100,000
Explanation / Answer
Ranking of Projects
Ranking of projects means selection of projects among various available projects. There are 4 basic criteria available to rank the project.
(‘1) Net Present Value
(‘2)- Internal rate of return (IRR)
(‘3) Profitability Index (PI)
(‘4) Payback Period
Sometimes there is conflicts arise when we rank the projects. One approach gives a higher ranking to project while other approach gives lower ranking to same project.
Projects ranking becomes important when a company have limited financial sources. The ranking based on IRR or PI may differ from the ranking based on NPV.
To resolve such conflicts always preference given to higher NPV criteria. Therefore in the given case we also select the projects based on NPV criteria.
Business Location
Capital Investment
Cumulative Investment Cost
NPV
Ranking
1
25,000
25,000
27,500
6
2
28,500
53,500
35,000
4
3
32,500
86,000
35,000
5
4
32,500
118,500
38,000
3
5
45,000
163,500
(15000)
Reject
6
54,000
217,500
(10,000)
Reject
7
63,250
280,750
92,000
2
8
73,000
353,750
100,000
1
Explanations
(‘a) Project 5 and 6 should be rejected due to negative NPV.
(‘b) Other projects are given ranking based on NPV. Highest NPV is the first preference.
(c ) Project 2 and 3 delivering same NPV but initial cost as well as cumulative cost is project 2 hence project 2 preferred over project 3.
Maximum Fund Available
Accepted Project
Required Investment
Investment made
Balance Fund
Beginning fund
-
150,000
Ranking 1
Project 8
73,000
73,0000
77,000
Ranking 2
Project 7
63,250
63,250
13,750
Ranking 3
Project 4
32,500
0
13,750
Total
136,250
As after investment in 8 and 7 we have left only $ 13,750 and the initial investment required for next project is $ 32,500 hence no investment can be made on the basis of assumption that no part investment allowed.
So total investment = $ 136,250
Business Location
Capital Investment
Cumulative Investment Cost
NPV
Ranking
1
25,000
25,000
27,500
6
2
28,500
53,500
35,000
4
3
32,500
86,000
35,000
5
4
32,500
118,500
38,000
3
5
45,000
163,500
(15000)
Reject
6
54,000
217,500
(10,000)
Reject
7
63,250
280,750
92,000
2
8
73,000
353,750
100,000
1
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