Question

You are in charge of one division of Bigfella Conglomerate Inc. Your division is subject to

capital rationing. Your division has 4 indivisible projects available, detailed as follows:

Project

Initial

Outlay IRR NPV

1 2 million 18% 2,500,000

2 1 million 15% 950,000

3 1 million 10% 600,000

4 3 million 9% 2,000,000

Instruction: If you must select projects subject to a budget constraint of 5 million dollars, which

set of projects should be accepted so as to maximize firm value? Show the detail calculation.

Answer 1

Bigfella Conglomerate Inc.

Capital rationing:

To select projects subject to a budget constraint of 5 million dollars, the set of projects that should be accepted in order to maximize firm value are:

Projects 1 and 4. These projects yielded the highest annual returns and NPV, and the combination could survive under the budget constraint.

Step-by-step explanation:

a) Data and Calculations:

Project Initial Outlay IRR NPV Expected Annual Returns

1 2 million 18% 2,500,000 $360,000 (18% * $2 million)

2 1 million 15% 950,000 $150,000 (15% * $1 million)

3 1 million 10% 600,000 $100,000 (10% * $1 million)

4 3 million 9% 2,000,000 $270,000 (9% * $3 million)

b) Based on a budget constraint of $5 million, the set of projects that should be accepted to maximize firm value is:

Project Initial Outlay IRR NPV Expected Annual Returns

1 2 million 18% 2,500,000 $360,000 (18% * $2 million)

4 3 million 9% 2,000,000 $270,000 (9% * $3 million)

Total 5 million 4,500,000 $630,000

c) In terms of the net present value of cash inflows versus cash outflows, projects 1 and 4 perform far better than projects 2 and 3 combined with project 4. The expected annual returns based on the Internal Rate of Return (IRR) also indicate that the combination of projects 1 and 4 outperform any other combination of projects.