Galaxy Satellite Co. is attempting to select the best group of independent proje
ID: 2729193 • Letter: G
Question
Galaxy Satellite Co. is attempting to select the best group of independent projects competing for the firm's fixed capital budget of $10,000,000. Any unused portion of this budget will earn less than its 20 percent cost of capital. A summary of key data about the proposed projects follows.
Project
PV of Inflows
Initial Investment
IRR
A
$3,050,000
$3,000,000
21%
B
$9,320,000
$9,000,000
25%
C
$1,060,000
$1,000,000
24%
D
$7,350,000
$7,000,000
23%
Use the NPV approach to select the best group of projects. (Note that just the PV of inflows is given, you must subtract the initial investment to find the NPV.)
Use the IRR approach to select the best group of projects. (Note that the discount rate or the cost of capital is 20%.)
Which projects should the firm implement based on your analysis of both techniques and given the capital rationing amount? Write an email to your boss, Andy Fast, the CFO, explaining your rationale proving the choices based on the considerations of shareholder value and the maximum investment budget. Keep in mind that you are less concerned with using the whole budget than with maximizing the total return to Galaxy satellite.
Project
PV of Inflows
Initial Investment
IRR
A
$3,050,000
$3,000,000
21%
B
$9,320,000
$9,000,000
25%
C
$1,060,000
$1,000,000
24%
D
$7,350,000
$7,000,000
23%
Explanation / Answer
a)
As per NPV Method, Project D has highest NPV of 350,000 which calls for $7,000,000 investment. Balance available investment is $3,000,000. Project B with 2nd highest NPV cannot be selected as maximum investment budget is $10,000,000. Project C would be selected with 3rd highest NPV i.e. 60,000. Hence, Project D & C should be taken up with total NPV is 410,000 for investment of $ 8,000,000.
b) As per IRR method, Project B & C should be accepted with highest two IRRs. Hence Total return would be $ 380,000 with Investment of $ 10,000,000.
c) Under capital rationing condition, NPV method should be selected for acceptance of projects with maximum return as a group with maximum investment of capital budget.
d) Email to Boss, Andy Fast, The CFO
Mr. Andy Fast
In scenario of capital rationing, its better to use NPV method to select appropriate projects so as to increase shareholder value. Choices should be based on total return on investment inspite of not filling entire capital budget. In order to maximize total return to Galaxy Satellite, Project C & D should be accepted with total return of $410,000 on total investment of $8,000,000. Remaining bugdet amount would earn less than its 20 percent cost of capital. Even if we try to complete budget amount & select either of 4 projects, we would be earning less than $410,000 + Earnings on balance $2,000,000. So primary motive should be increase shareholders value i.e. EPS (earnings per share) with given amount of investment.
Thanks!
Warm Regards
Project PV of Investment Initial Investment NPV A 3,050,000 3,000,000 50,000 B 9,320,000 9,000,000 320,000 C 1,060,000 1,000,000 60,000 D 7,350,000 7,000,000 350,000Related Questions
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