Question

The capital budgeting committee for Laroche Industries is meeting. Laroche is a North American conglomerate that has several divisions. Schoeman Products, a division of Laroche, has evaluated several investment projects and now must choose the subset of them that fits within its C$40 million capital budget. The outlays and NPVs for the six projects follow. Schoeman cannot buy fractional projects and must buy all or none of a project. The currency amounts are in millions of Canadian dollars.

Project	Outlay	PV of Future Cash Flows	NPV
1	31	44	13
2	15	21	6
3	12	16.5	4.5
4	10	13	3
5	8	11	3
6	6	8	2

Schoeman wants to determine which subset of the six projects is optimal.

A proposal comes from the division Society Services. The cash flows relating to the project is as follows:

An outlay of C$190 million at time 0.

Cash flows of C$40 million per year for years 1-10 if demand is high.

Cash flows of C$20 million per year for years 1-10 if demand is low.

The probability of high demand is 0.50, and the probability of low demand is 0.50.

The required rate of return is 10 percent.

The internal auditor for Laroche Industries has made several suggestions for improving capital budgeting processes at the company. The internal auditor’s suggestions are as follows:

Suggestion 1: “In order to put all capital budgeting proposals on an equal footing, the projects should all use the risk-free rate for the required rate of return.”

Suggestion 2: “When rationing capital, it is better to choose the portfolio of investments that maximizes the company NPV than the portfolio that maximizes the company IRR.”

1. The optimal subset of the six projects that Schoeman is considering consists of which projects?
   1. 1 and 5
   2. 2, 3, and 4
   3. 2, 3, and 5
   4. 2, 4, 5, and 6

2. What is the NPV (C$ millions) of the project for Society Services?
   1. -6.11
   2. -5.66
   3. 2.33
   4. 5.58

3. Should the capital budgeting committee accept the internal auditor’s first and second suggsestion?

Suggestion 1	Suggestion 2
a-NO	NO
b-NO	YES
c-YES	NO
d-YES	YES

Answer 1

1. Answer is a.1 and 5.

The optimal subset of the six projects that Schoeman is considering consists of projects 1 and 5 because both these projects have initial outlay within the capital budget of $40 million and have the highest NPV among other combination of projects.

initial outlay = project 1 + project 5 = $31 million + $8 million = $39 million

NPV = project 1 + project 5 = $13 million + $3 million = $16 million

2. Answer is -5.66.

NPV = sum of present value of cash flows - initial outlay

sum of present value of cash flows = year 1 cash flow/(1+required return) + year 2 cash flow/(1+required return)2 + year 3 cash flow/(1+required return)3 .... + year 10 cash flow/(1+required return)10

Year	Cash flow if high demand	Probability	Cash flow if low demand	Probability	Total cash flow
0					-190
1	40	0.5	20	0.5	30
2	40	0.5	20	0.5	30
3	40	0.5	20	0.5	30
4	40	0.5	20	0.5	30
5	40	0.5	20	0.5	30
6	40	0.5	20	0.5	30
7	40	0.5	20	0.5	30
8	40	0.5	20	0.5	30
9	40	0.5	20	0.5	30
10	40	0.5	20	0.5	30
required return					10%
NPV (C$ millions)					-5.66

Calculation

3. Answer is b-No, Yes.

first suggestion is not correct because each project has different kind of risk and return. some projects are riskier than others. so each project can't use risk-free rate for the required rate of return.

second suggestion is correct because NPV is a better measure than IRR. for any project which has one or more negative cash inflows, there will be 2 IRRs. so NPV is a better measure as it is either positive or negative.