P12-18 Capital rationing: IRR and NPV approaches Valley Corporation is attemptin

Question

P12-18 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 in flows that is less than the initial investment. The firm has summarized, in the following table, the key data to be used in selecting the best group of projects. a. Use the internal rate of return (IRR) approach to select the best group of projects. b. Use the net present value (NPV) approach to select the best group of projects. c. Compare, contrast, and discuss your findings in parts a and b. d. Which projects should the firm implement? Why?

Explanation / Answer

a) Ranking of projects using IRR approach Project Rank IRR Initial investment Cumulative Investment PV @ 15% F 1 23% 2500000 2500000 3000000 E 2 22% 800000 3300000 900000 G 3 20% 1200000 4500000 1300000 Total 4500000 5200000 NPV of this group 700000 (5200000 - 4500000) b) Ranking of projects using NPV approach Project Initial investment PV @ 15% NPV Ranking acc.to NPV A -5000000 5400000 400000 Investment exceeds the capital available B -800000 1100000 300000 2 C -2000000 2300000 300000 2 D -1500000 1600000 100000 3 E -800000 900000 100000 3 F -2500000 3000000 500000 1 G -1200000 1300000 100000 3 Project A is eliminated as its investment exceeds the available capital. F is chosen 1st. Between B&C for the same NPV - C uses the balance capital - But F&B add upto NPV of 800000 SO,F,B &G uses the entire capital & gives maximum NPV The best group will be as follows Initial investment NPV F -2500000 500000 B -800000 300000 G -1200000 100000 TOTAL -4500000 900000 c) Ranking as per IRR approach gives NPV of $ 700000 Ranking as per NPV approach gives NPV of $ 900000 As shareholder wealth maximisation is the objective of any firm NPV approach of project selection seems to be recommendable. d)The firm should implement Projects, F,B & G as it utilises the entire capital available( $ 4500000) to give maximum NPV ($900000)

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