Capital rationing—IRR and NPV approaches Valley Corporation is attempting to sel
ID: 2673717 • Letter: C
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.Project Initial investment IRR Present value of flows at 15%
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 200,000 20 1,300,000
a. Use the internal rate of return (IRR) approach to select the best group of projects
b. Use the net present value (NPV) approach to select the best group of projects
c. Compare, contrast, and discuss your findings in parts a and b.
d. Which projects should the firm implement? Why?
Explanation / Answer
The total budget is limited at $4.5 million a) Choose the projects with the highest IRR ----> Project B,E,F,G with the highest average IRR of 21.44% ( The unused portion $200000 earns IRR of 15% ) b) Choose the projects with the highest NPV ----> Project B,C,D,G with the highest NPV (at15%) of $6.3 million c) Relying on only one criteria is not a good strategy to choose project First, we have to look at the IRR and compare its with our cost of capital if a project's IRR > cost of capital then choose that project Second we need to use our cost of capital to find NPV, if project's NPV > 0 then choose that project Pros and Cons of each method are as followings: Advantages: With the NPV method, the advantage is that it is a direct measure of the dollar contribution of the project. With the IRR method, the advantage is that it shows the return on the original money invested. Disadvantages: With the NPV method, the disadvantage is that the project size is not measured. With the IRR method, the disadvantage is that, at times, it can give you conflicting answers when compared to NPV for mutually exclusive projects. The multiple IRR problem can also be an issue. While NPV and IRR are useful metrics for analyzing mutually exclusive projects - that is, when the decision must be one project or another - these metrics do not always point you in the same direction. This is a result of the timing of cash flows for each project. In addition, conflicting results may simply occur because of the project sizes. d) The firm should implement projects with the highest NPV since it will give the true highest dollar return to the firm So, choose projects B,C,D,G
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