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A firm utilizes a strategy of capital rationing, which is currently $375,000 and is considering the following two projects: Project A has a cost of $335,000 and the following cash flows: year 1 $140,000; year 2 $150,000; and year 3 $100,000. Project B has a cost of $365,000 and the following cash flows: year 1 $220,000; year 2 $110,000; and year 3 $150,000. Using a 6% cost of capital, which decision should the financial manager make?

Respuesta :

Answer:

The manager should pick project B

Explanation:

To determine what decision the manager should make, the NPV of both projects should be calculated.

Net present value is the present value of after tax cash flows from an investment less the amount invested.

NPV can be calculated using a financial calculator

NPV for project A

Cash flows:

Year 0 = $-335,000

year 1 = $140,000

year 2 = $150,000

year 3 = $100,000

I = 6%

NPV= $14,536.87

NPV for project B

Cash flows:

Year 0 = $-365,000

year 1 = $220,000

year 2 = $110,000

year 3 = $150,000

I = 6%

NPV= $66,389.67

Both projects are profitable but because the firm uses capital rationing , the manager has to pick the now profitbale project, which is project B.

To find the NPV using a financial calacutor:

1. Input the cash flow values by pressing the CF button. After inputting the value, press enter and the arrow facing a downward direction.

2. After inputting all the cash flows, press the NPV button, input the value for I, press enter and the arrow facing a downward direction.

3. Press compute

I hope my answer helps you

The firm should select project B as it has more NPV.

What is capital rationing?

It is a method in which the company has limited fund, so it undertakes the project with maximum return. This method employees the net present value method.

Given:                                  project A   project B

year0(Initial investment) $335,000    $365,000

year1(cash inflows)           $140,000  $220,000

year2(cash inflows)           $150,000   $150,000

year3(cash inflows)          $100,000   $150,000

cost of capital=6%

Present value of Project A

year0(Initial investment)   $335,000        1                   ($335,000)

year1(cash inflows)           $140,000          0.9433        $132,062    

year2(cash inflows)          $150,000          0.8999        $134,985

year3(cash inflows)          $100,000          0.8396        $83,960

cost of capital=6%                                                            $351,007

NPV=16,007

Present value of Project B

year0(Initial investment)   $365,000         1                   ($365,000)

year1(cash inflows)           $220,000        0.9433          $207,526

year2(cash inflows)          $150,000         0.8999         $134,985

year3(cash inflows)           $150,000         0.8396         $125,940

cost of capital=6%                                                           $46,8451

NPV= 103,451

So as the NPV of project B is higher than NPV of project A, the manager should select project B.

Therefore, the manger should select project B.

Learn more about capital rationing here:

https://brainly.com/question/19582310

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