Question

2. Big Mountain Co has a 12% cost of capital and a $1 million capital budget. Select the best projects from the following assuming any unused funds will earn less than 12% under a) the IRR approach and b) the NPV approach | PV OF CASH FLOWS @ 12% PROJECT | INITIAL INVESTMENT | 1RR 12% 19 18 14 13 17 20 |384,000 210,000 125,000 990,000 570,000 150,000 960,000 300,000 200,000 100,000 900,000 500,000 100,000 800,000

I HAVE THE BA II PLUS AND THE TI-84 PLUS, PLEASE SHOW YOUR CALCULATED WORK. THANKS!

Answer 1

Solution

This is a Capital rationing Problem in which we have a budget of 1 Million and seleth the best projects for investments using the IRR and NPV Method.

1. IRR Method

Under this method we begin by selecting the project with best IRR and take the average IRR of the combination of projects we have selected. The combination with highest average IRR is selected for investment. So we begin by project G which has highest IRR of 20% and project B which has IRR of 19%. We cannot select anymore as we have reached the budget amount. Lets calculate the average IRR.

Project	Investment	IRR
G	800000	20
A	200000	19
Total	1000000	19.5

As calculated above average IRR of selected combination is 19.5%. No other combination will yield higher average IRR has these projects had highest IRR and are utilising the budget completely. In case you want to check, you can check yourself for practice.

2. NPV Method

In the given Method we begin by selecting Projects with highest NPVs and combine the projects so that they reach the budget amount and total NPV is the highest. The Combination with highest total NPV is selected.

Let us Calculate the NPV first

Project	Investment	PV of Cash Flows@12%	NPV(PV - Inv)
A	300000	384000	84000
B	200000	210000	10000
C	100000	125000	25000
D	900000	990000	90000
E	500000	570000	70000
F	100000	150000	50000
G	800000	960000	160000

Now lets calculate the total NPV for different Project Combinations

Combinations	Sum of NPVs	Investment
D&F	140000	1000000
D&C	115000	1000000
G&B	170000	1000000
G&F&C	235000	1000000
E&A&B	164000	1000000
E&A&F&C	229000	1000000

As you can see from the table above Combination of Project Combination G,F and C is having the highest NPV of 2,35,000 and hence project G, F and C will be selected.

To sum up, if IRR method is used projects G and A will be selected and if NPV method is used project G, F and C will be selected.

Hope this answers your question.

Good Luck!