Question

Capital rationing—NPV approach A firm with a 13.3% cost of capital must select the optimal group of projects from those shown in the following table, given its capital budget of $1.20 million. Project Initial investment Damonu $300,000 300,000 300,000 900,000 500,000 100,000 800,000 NPV at 13.3% cost of capital $80,000 9,000 18,000 84,000 71,000 49,000 152,000

Answer 1

The optimal option will be the one in which the NPV will be the greatest.

NPV of option A is computed as follows:

= $ 80,000 + $ 9,000 + $ 71,000

= $ 160,000

NPV of option B is computed as follows:

= $ 80,000 + $ 18,000 + $ 71,000 + $ 49,000

= $ 218,000

NPV of option C is computed as follows:

= $ 18,000 + $ 49,000 + $ 152,000

= $ 219,000

NPV of option D is computed as follows:

= $ 84,000 + $ 18,000

= $ 102,000
So the option C i.e. Project C, F and G will be the correct answer

The present value is computed as shown below:

= NPV + Initial Investment

The present value of Project A is computed as follows:

= $ 300,000 + $ 80,000

= $ 380,000

The present value of Project B is computed as follows:

= $ 300,000 + $ 9,000

= $ 309,000

The present value of Project C is computed as follows:

= $ 300,000 + $ 18,000

= $ 318,000

The present value of Project D is computed as follows:

= $ 900,000 + $ 84,000

= $ 984,000

The present value of Project E is computed as follows:

= $ 500,000 + $ 71,000

= $ 571,000

The present value of Project F is computed as follows:

= $ 100,000 + $ 49,000

= $ 149,000

The present value of Project G is computed as follows:

= $ 800,000 + $ 152,000

= $ 952,000

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