Question

Emo Incorporated is reviewing the following projects for next year's capital program. Project Initial Investment Length in Years Annual Cash Flow A $3.0 million 6 $719,374 B 3.5 million 5 970,934 C 4.0 million 7 904,443 D 5.0 million 4 1,716,024 E 6.0 million 6 1,500,919 F 7.0 million 5 1,941,868 G 8.0 million 7 1,725,240 Projects A and B are mutually exclusive and so are Projects D and E. Griffin-Kornberg has 10.5% cost of capital and a maximum of $14 million to spend on capital projects next year. Use capital rationing to determine which projects should be included in Emo's capital program.

Answer 1

Projects C, D and B should be carried out since they yield the highest profits. Total investment = $12.5 million.

I based my decision on how much value each project generated (NPV) and how profitable they were. If the company really needed to invest as much of the $14 million as possible, then you could change project D for E, fro a total investment of $13.5 million. Projects B and F yield basically the same gains, but the investment for project F is too high and there are better alternatives.

Step-by-step explanation:

Project Initial Investment Length in Years Annual Cash Flow

A $3.0 million 6 $719,374

B $3.5 million 5 $970,934

C $4.0 million 7 $904,443

D $5.0 million 4 $1,716,024

E $6.0 million 6 $1,500,919

F $7.0 million 5 $1,941,868

G $8.0 million 7 $1,725,240

NPV

A = -$3.0 million + (4.29218 x $719,374) = -$3.0 million + $3,087,682.70 = $87,682.70

B = -$3.5 million + (3.74286 x $970,934) = -$3.5 million + $3,634,070.03 = $134,070.03

C = -$4.0 million + (4.7893 x $904,443) = -$4.0 million + $4,331,648.86 = $331,648.86

D = -$5.0 million + (3.13586 x $1,716,024) = -$5.0 million + $5,381,211.02 = $381,211.02

E = -$6.0 million + (4.29218 x $1,500,919) = -$6.0 million + $6,442,214.51 = $442,214.51

F = -$7.0 million + (3.74286 x $1,941,868) = -$7.0 million + $7,268,140.06 = $268,140.06

G = -$8.0 million + (4.7893 x $1,725,240) = -$8.0 million + $8,262,691.93 = $262,691.93

Profitability index

A = NPV / initial investment = $87,682.70 / $3,000,000 = 2.92%

B = NPV / initial investment = $134,070.03 / $3,500,000 = 3.83%

C = NPV / initial investment = $331,648.86 / $4,000,000 = 8.28%

D = NPV / initial investment = $381,211.02 / $5,000,000 = 7.62%

E = NPV / initial investment = $442,214.51 / $6,000,000 = 7.37%

F = NPV / initial investment = $268,140.06 / $7,000,000 = 3.83%

G = NPV / initial investment = $262,691.93 / $8,000,000 = 3.28%

ranking of projects based on profitability

C = $4 million investment, 8.28%

D = $5 million investment, 7.62% mutually exclusive with E

E = $6 million investment, 7.37% mutually exclusive with D

B = $3.5 million investment, 3.83% mutually exclusive with A

F = $7 million investment, 3.83%

G = $8 million investment, 3.28%

A = $3 million investment, 2.92% mutually exclusive with B

Projects C, D and B should be carried out since they yield the highest profits. Total investment = $12.5 million.