Question

Use the following information for parts a, b, and c below. For all 3 cases, the marginal cost of capital is 10%. These questions require short, to-the-point answers. I am interested in seeing if you know the most appropriate criterion to look for in each case.Also, make sure you answer all questions in each section.

                                                     Payback        NPV          NPV              NPV     

                  Project           IRR     (years)           at 0%           at 10%          at 15%

                  A                     17%        5                  $10,000         $1,250                  $290

                  B                     21%        4                 9,700      1,100               305

                 C                     18%        4                  9,300       1,125               315

c. Assume again that the 3 projects are independent projects, but the firm now facessevere capital rationing and can choose only one project. Which project should they select? Which criterion is appropriate in this case? Will there be an opportunity cost to the stockholders in this              case?If so, how much? (4 pts)

Answer 1

Since the projects are independent and the firm is facing capital rationing, the project to be chosen is project A because it has the highest NPV at the marginal cost of capital i.e. 10%. Even though the payback period is higher than the other 2 projects, however the same is neutralised with the NPV approach. Also, it has the lowest IRR and hence must be selected.

Yes, there is always an opportunity cost attached to the shareholders' funds. Even though the entity is not oblidged to pay dividends, but there is an expectation of equity shareholders which is referred to as the cost of equity i.e. Ke. Any project which is not selected is an opportunity cost. However, choosing project A would mean that the next best alternative is done away with and hence the possibility of incurring a loss by ignoring the opportunity is done away with.