Question

Vally Corporation is attempting to select the best of a group of independent projects competing for the firm’s fixed capital budget of $4.5 million for the upcoming year. The firm has a 15% Weighted Average Cost of Capital (WACC). The firm has summarized in the following table the key data to be used in selecting the best group of projects.

	Initial	Profitability	Net Present
Project	Investment	Index (PI)	Value (NPV) @ 15%
A	$5,000,000	1.08	$400,000
B	$800,000	1.375	$300,000
C	$2,000,000	1.15	$300,000
D	$1,500,000	1.0667	$100,000
E	$800,000	1.125	$100,000
F	$2,500,000	1.2	$500,000
G	$1,200,000	1.0833	$100,000

a. Given that the firm has a maximum $4.5 million available for capital expenditures, which project(s) should be selected according to the “Profitability Index” (PI)?

1. What is the total initial investment value of the projects you selected in Part a above?

b. Given that the firm has a maximum $4.5 million available for capital expenditures, which project(s) should be selected according to the “Net Present Value” (NPV)?

1.What is the total initial investment value of the projects you selected in Part b above?

c. Under the circumstances that exist in this problem, which method – “Profitiability Index” or “Net Present Value” – should be used to determine the projects selected for the firm’s capital budget for the upcoming year? Why should this method be used?

Answer 1

Answer a. If we consider only the profitability index, we should select the projects with the maximum profitability index with total investments less than $4.5 million. Sorting the data according to PI, we get-

We observe that the Profitability index of B and F is the highest. Thus, they have to be selected. Though the index of C is next to be selected, we cannot select this as the total investment amount will be more than $4.5 million if we choose to select this. Thus, we will take the next best alternative. Thus, final choice becmes projects B,F and E.

Answer 1. Total Investment Value for these projects- $ 4.1 million

Further, we can observe that total NPV comes out to be $900,000

Answer b. Based on NPV method- we select F as a priority, followed by B, ollowed by E. Theoretically, we should be indifferent about the choice of B and C due to same NPV, but this is not the case as total NPV turns out to be lower considering other options generate less NPV.

Due to capital constraints, we will select F,B,E (same as what was chosen in problem a) - Total NPV - 900,000, Total Investment - 4.1 million USD.

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Answer c.

PI (Profitability Index) should be used in this case as a method of choice. Despite the indifference in the answer, we have capital constraints here. Whenever we have capital constraints, NPV does not take into account those. There have been several criticisms around NPV ignoring the capital constraints and choice of projects going wrong.

Thus, it is better to use Profitability index as it also considers the investment limitations in the project.

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