Question

ABC Pharmaceutical's CFO has budgeted $18 million for capital expenditures during 2017 for R&D. It turns out the R&D department has a number of good, independent opportunities to invest in. The cost of capital is 12%.

Table (figures in millions).

Project	Investment	NPV	NPV/Investment
Q	10.5	5.5	0.52
R	2.0	0.5	0.25
S	6.0	2.5	0.42
T	7.5	2.0	0.27
U	1.5	1.0	0.67
V	3.0	1.0	0.33

Assume the $18 million budget can not be increased. Which projects should be undertaken? Select all that apply.

Q

R

S

T

U

V

Show the work, please.  

Answer 1

the company is advised to follow the ranking on the basis of NPV method and invest in projects Q, S and U.

Project	Investment	NPV	NPV/Investment	Rank as per PI	Rank as per NPV
Q	10.50	5.50	0.52	2	1.00
R	2.00	0.50	0.25	6	6.00
S	6.00	2.50	0.42	3	2.00
T	7.50	2.00	0.27	5	3.00
U	1.50	1.00	0.67	1	4.00
V	3.00	1.00	0.33	4	5.00

Project	Investment	PI	NPV
U	1.5	0.52	1
Q	10.5	0.42	5.5
S	6	0.67	2.5
Total	18		9

Answer 2

                 

We should select projects such that the total NPV from these projects is maximized. To achieve this outcome, a good heuristic is to give priority to projects with high NPV/investment ratios. (This heuristic is known as a greedy approximation algorithm.

Q, S and U have the highest NPV/investment ratios, and they happen to require $18 million investment in total. These are the projects that should be undertaken, and their joint NPV is 5.5+2.5+1.0=$9 million.