Question

Optimization of Capital Budgets

University Hospital has four capital projects under consideration with the following investments and projected cash flows. What is their optimal capital budget allocation if their corporate cost of capital is 12%?

	Year	0	1	2	3	4	5
Project
A		(600,000)	50,000	90,000	150,000	200,000	250,000
B		(400,000)	80,000	100,000	100,000	100,000	100,000
C		(700,000)	100,000	220,000	250,000	250,000	250,000
D		(350,000)	90,000	120,000	150,000	150,000	150,000

Optimal Budget??

Answer 1

IRR is rate of return from Project. Select the project in the manner in which these gives higher Rate of Return.

IRR of Project A:

IRR = Rate at which least +ve NPV + [ NPV at that rate / change in NPV due to 1% change ] * 1%

= 5% + [ 19249.38 / 20803.72 ] * 1%

= 5% + 0.93%

= 5.93%

Project B:

IRR:

IRR = Rate at which least +ve NPV + [ NPV at that rate / change in NPV due to 1% change ] * 1%

= 6% + [ 2368.45 / 11040.30] * 1%

= 6% + 0.21%

= 6.21%

Project C - IRR:

IRR = Rate at which least +ve NPV + [ NPV at that rate / change in NPV due to 1% change ] * 1%

= 14% + [ 3607.27 / 18687.59 ] * 1%

= 14% + 0.19%

= 14.19%

Project D - IRR:

IRR = Rate at which least +ve NPV + [ NPV at that rate / change in NPV due to 1% change ] * 1%

= 23% + [ 1910.99 / 8001.35] * 1%

= 23% + 0.24%

= 23.24%

Proct D IRR - 23.24%

Project C IRR - 14.19%

Project B IRR - 6.21%

Project A IRR - 5.93%

As project D & C are giving IRR > cost of capital, can select these Projects and Ignore Project A & B.

In Project C & D, FIrst allocate the amount to Project D as it is having higher IRR, if any funds are leftover then use it for Project C.