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%

1.) 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.)

2.) Use the IRR approach to select the best group of projects. (Note that the discount rate or the cost of capital is 20%.)

3.) 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.

Answer 1

1.

NPV = PV of cash inflows - Initial outlay

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 = $350,000

We can select multiple projects as they are independent but should be within the budget.

The objective here is to maximize the NPV.

We will select Project C & D as they result in a combined NPV of $410,000 and initial outlay of $8,000,000 which is within our budget. Any other combination results in NPV < $410,000.

2)

Decision rule for IRR: Select the project if IRR > Cost of capital. Otherwise reject.

Higher IRR, the better it is.

Cost of capital = 20%

All the projects have IRR > 20% which means all of them are profitable but we have to select the one which are most profitable and within our budget.

Project B & C have highest IRR and their combined outlay is $10,000,000 which meets our budget. So, we should select Project B & C.

3) NPV method is preferred over IRR method. It is more sound and reliable. As we are more concerned with maximizing the total return the firm should implement Project C & D as it maximises the shareholder value with highest combined NPV of $410,000.