Question

A firm must choose from six capital budgeting proposals outlined below. The firm is subject to capital rationing and has a capital budget of​ $1,000,000; the​ firm's cost of capital is 15 percent. Please show the work.

Project Initial Investment IRR NPV
1 $200,000 19% $100,000
2 400,000 17 20,000
3 250,000 16 60,000
4 200,000 12 -5,000
5 150,000 20 50,000
6 400,000 15 150,000

Using the internal rate of return approach to ranking projects, which projects should the firm accept?

Using the net present value approach to ranking projects, which projects should the firm accept?

Answer 1

Answer:

On IRR basis projects 1, 2, 3, and 5 will be selected.

On NPV basis projects 1, 3, 5,  and 6 will be selected.

Explanation:

The firm will accept or choose all the project that has a higher or equal internal rate of interest than cost of capital. However, in the given case project 4 has a lower internal rate of interest (12 percent) than the cost of capital. Thus, projects 1, 2, 3, and 5 will be chosen by the firm. While the firm has budget constraints so it will have no money for projects 4 and 6.

The firm will select all the projects with positive NPV when there is no budget constraint. But in case of budget constraint, the firm will select the project that has high NPV. Thus, Project 1, 6, 3, and 5 will be selected and there will be no money left for projects 2 and 4.