Question

There is a general consensus among both academics and practitioners, that NPV is the best investment decision rule, because it takes into account all of the cash flows of a project, its risk, and time value of money, as well as being a good measure of the economic value created by the project for a company's shareholders. Nevertheless, NPV is not perfect. One of the down sides of NPV, is that it does not reflect the sizeof the project being considered. This means that when companies have limited resources, as they do in the real world (i.e. there is capital rationing), and when they have multiple projects to choose from, again, as they do in the real world, they cannot rely solely on individual project NPVs. Please meet with your team to answer the following:

1. Suppose a company has three independent projects to choose from, A, B, and C, and all have positive NPVs, i.e. $1,000, $700, and $400, for each project, respectively. Assume also that projects A, B, and C require initial investments of $1,600, $1,100, and $500, and respectively. If the company has a total budget of $1,600 that it can allocate to capital projects, please answer the following:

a. What are the different project combinations (among A, B, and C) that could be taken together, assuming you (try to) invest as much of the $1,600 total budget as possible?

b. Which one of the project combinations, identified in part (a), should be picked and why?

c. Would it be possible to use the Profitability Index (PI) method to give us the correct answer (about which combination of projects to pick)? Please find the PI for each standalone project, A, B, and C, and check to see if we can use it to select the same set of projects as in part (b). (Hint: the PI of project X can also be computed from: (NPV of X + Initial Investment for X) / (Initial Investment for X).

2. (Here is a very different type of question): Traditional capital budgeting rules need some estimate of a project's future cash flows or profits, as well as estimates of the project's risk (and required return). Please search the Web for some examples of firms and/or industries where this information is inherently very difficult to obtain, or is extremely unreliable. Are there any alternative decision rules (even industry specific ones) that may be used other than the ones explicitly covered in this chapter (i.e. NPV, PI, IRR, Payback, Discounted Payback, AAR, etc)?

Answer 1

(a) If the company has a total budget of $1600, then the possible combinations are

1. It invests entire amount in Project A
2. It invests in both Project B and Project C ($1100+$500 = $1600)

(b) NPV of project A = $1000 (Combination 1)

NPV of Project B + Project C = $700+$400 = $1100 (Combination 2)

As, NPV of Project (B+C) is greater than NPV of Project A, therefore, Combination @ should be picked as it yields higher return with same initial investment of $1600

(c) PI index calculates value created per unit of investment i.e it is better than NPV as it takes Initial Investment into account and not just amount of cashflow.

Pi=(NPV of X + Initial Investment for X) / (Initial Investment for X).

PI of project A (Combination 1) = (1000+1600)/1600 = 1.625

PI of project B = (700+1100)/1100 = 1.6363

PI of project C = (400+500)/500 = 1.8

PI of project (B+C) (Combination 2) = (1100+1600)/1600 = 1.6875

As per PI, only project C should be considered as it has the highest PI. But selecting only Project C would result in underutilisation of Resources, Therefore ComBINATION 2 I.E PROJECT C+B should be selected as it yields positive PI of 1.6875