Capital rationing: IRR and NPV approaches Valley Corporation is attempting to se

Question

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 inflows 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. Use the internal rate of return (IRR) approach to select the best group of projects. Use the net present value (NPV) approach to select the best group of projects. Compare, contrast, and discuss your findings in parts a and b. Which projects should the firm implement? Why?

Explanation / Answer

Fixed capital budget                                        4.5 Million Project initial investment IRR Present value of inflow A                         (5,000,000) 17%                                       5,400,000 B                             (800,000) 18                                       1,100,000 C                         (2,000,000) 19                                       2,300,000 D                         (1,500,000) 16                                       1,600,000 E                             (800,000) 22                                           900,000 F                         (2,500,000) 23                                       3,000,000 G                         (1,200,000) 20                                       1,300,000 a) IRR approach Project initial investment IRR Status cum investment F                         (2,500,000) 23 select             (2,500,000) E                             (800,000) 22 select             (3,300,000) G                         (1,200,000) 20 select             (4,500,000) C                         (2,000,000) 19 B                             (800,000) 18 D                         (1,500,000) 16 A                         (5,000,000) 17 b) NPV Project initial investment IRR Present value of inflow NPV Status cum investment F                         (2,500,000) 23                                       3,000,000                   500,000 select             (2,500,000) A                         (5,000,000) 17%                                       5,400,000                   400,000 B                             (800,000) 18                                       1,100,000                   300,000 select             (3,300,000) C                         (2,000,000) 19                                       2,300,000                   300,000 D                         (1,500,000) 16                                       1,600,000                   100,000 E                             (800,000) 22                                           900,000                   100,000 select             (4,100,000) G                         (1,200,000) 20                                       1,300,000                   100,000 c) Projects selected IRR NPV F F E B G E NPV is resulting in untilised fund of .4 Million d) F, E and G as it utlises full funds and has better IRR and NPV than other projects

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