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Chapter 4: Q22BP (page 412)

The Suboptimal Glass Company uses a process of capital rationing in its decision making. The firm’s cost of capital is 10 percent. It will only invest \(77,000 this year. It has determined the internal rate of return for each of the following projects:

Project

Project size

Internal rate of return

A

\)10,500

21%

B

30,500

22

C

25,500

18

D

10,500

13

E

10,500

20

F

20,500

11

G

10,500

16

a. Select the projects that the firm should accept.

b. If Projects A and B are mutually exclusive, how would that affect your overall answer? That is, which projects would you accept in spending the $77,000?

Short Answer

Expert verified

Answer

  1. The business entity must accept projectsB, A, E, and C.

  2. Project A will be replaced by project G.

Step by step solution

01

Definition of Profitability Index

The profitability index is the metric that determines the attractiveness of the different available projects to make an investment decision. Under this metric, the present value of the cash flows generated from the investment is compared with the initial investment.

02

Selection of the project

Ranking of investment as per IRR:

Project

IRR

Project Size

Total budget

B

22%

$30,500

$30,500

A

21

10,500

41,000

E

20

10,500

51,500

C

18

25,500

77,000

G

16

10,500

87,500

D

13

10,500

98,000

F

11

20,500

118,500

As the business entity wishes to invest only $77,000, it must accept projects B, A, E, and C as they are ranked in the first four projects according to IRR.

03

Selection of project when projects A and B are mutually exclusive

If the project A and project B are mutually exclusive, then the business entity should select project B. The other three projects will be E, C, and G. Project A will be replaced by project G as they have the same project size.

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