Question

You are the CFO of floor Covering America Inc. As part of the planning and budgeting process, each division head from the company's five divisions has submitted their capital request. the following are the facts and figures from each division：

division	I	II	III	IV	V
capital requested	-10,000	-30,000	-30,000	-20,000	-10,000
NPV	5,160	2,010	490	4,870	2,290
IRR	29%	12%	11%	23%	15%
Profitability Index	1.5	1.1	1.0	1.2	1.2

The projects above are "All or Nothing" - meaning for example that division I requires an investment of $10M immediately, and cannot accept partial funding of its project. The Projects are NOT mutually exclusive. The cost of capital for each of the project is 10%.

(a) Suppose the company has unlimited capital and can invest in all of the projects if deemed optimal, which of the projects should be funded? Why?

(b) Because of challenging capital market conditions, the company can only raise $50M for investment in next year's projects. Which of the projects should be funded? why?

Answer 1

a) If the company has unlimited capital then those projects should be funded which has positive NPVs and IRRs higher than the cost of capital. In this case, all the projects should be funded as all have positive NPVs and IRRs higher than the cost of capital.

b) The company now have $ 50 million to invest so it should look at the profitability index of all the projects and select the projects with the highest profitability indexes. Therefore, going by this, the following projects should be funded in this order:-

1) Project I with the highest profitability index and capital requirement of $ 10 million

2) Project IV with the profitability index of 1.2 (same as V) but preferred over V as it has more NPV. It has a capital requirement of $ 20 million.

3) Project V with the profitability index of 1.2 and capital requirement of $ 10 million.

The total capital used is $ 40 million and we have $ 10 million left now. Therefore, the other 2 projects cannot be funded as their capital requirement exceeds the capital budget.