Question

"When a firm chooses to increases its capital budget, the less profitable projects it would choose rather than the ones picked out initially. "How do we rank projects; what are the models we use to decide which projects to initially choose?

If the goal of management is to maximize shareholder wealth, how can a corporation excuse look at anything other than the bottom line?

Answer 1

The commonly used models used to initially rank projects are below.

Net present value (NPV)

It is the difference between present value of cash inflows (PVCIF) and present value of cash outflows (PVCOF). It is one of the most basic and easy to understand techniques; hence widely used.

NPV = PVCIF - PVCOF

Situation	Decision
NPV > 0	Accept the project
NPV = 0	Neutral
NPV < 0	Reject the project

It is inferred that project with positive NPV will be profitable as the benefit (Present value of cash inflows – PVCIF) will be greater than Cost (Present value of cash outflows – PVCOF).

Internal rate of return (IRR)

It is the rate of return yielded by the project i.e. the rate at which NPV = 0 and PVCIF = PVCOF. It is used to evaluate the attractiveness of a particular project. It is compared with the company’s target rate of return for decision making as follows:

Situation	Decision
IRR > Target Rate of return	Accept the project
IRR = Target Rate of return	Neutral
IRR < Target Rate of return	Reject the project

Profitability index (PI)

It is an index which expresses the relationship between PVCIF and PVCOF. It quantifies the value created per unit of investment in a project, hence it is used under situations of limited availability of capital.

PI = PVCIF / PVCOF

Situation	Decision
PI > 1	Accept the project
PI = 1	Neutral
PI < 1	Reject the project

At the time of initial ranking, the projects having highest postiive NPV / highest PI ratio / highest IRR will be selected first.

Subsequently, when there is further availability of capital, the project with next highest NPV / next highest PI ratio / next highest IRR will be selected and so on.

The goal of management is to maximize shareholder's wealth, which is reflected in the market value of shares held by them. The market value of shares is mainly affected by the profitability of the company, but there are other factors determining the market value, such as, economical and political factors, interest rates, dividend etc.

When the management wishes to maximize shareholder's wealth, it should definitely look at the profitability of its projects. However, it should also focus on sustainable growth of the company in order to retain / increase the market price of shares.