- 15 Marks
FM – L2 – Q66 – Capital rationing
Question
A company, Kumasi Ventures Ltd, has identified five investment projects that it would like to undertake. None of the investments can be delayed. If they are not undertaken now, the opportunity to invest will be lost. Details of the five investments are as follows:
| Investment | Capital investment required in Year 0 | NPV of the investment |
|---|---|---|
| GH¢ | GH¢ | |
| A | 60,000 | 12,000 |
| B | 80,000 | 21,600 |
| C | 50,000 | 8,500 |
| D | 45,000 | 10,800 |
| E | 55,000 | 9,900 |
Capital is in short supply, and only GH¢150,000 is available for investment. The company cannot therefore undertake all five investments.
Required:
In order to maximise the total NPV of its investments, recommend which investments to undertake:
(a) assuming that all five investment projects are divisible.
(b) assuming that none of the five investments is divisible, and the choice is either 0% or 100% of each investment.
Answer
(A).
Total NPV is maximised by maximising the NPV per GH¢1 invested.
| Investment | Capital investment | NPV | NPV per GH¢1 | Ranking | Investment | NPV |
|---|---|---|---|---|---|---|
| A | 60,000 | 12,000 | 0.20 | 3 | 60,000 | 12,000 |
| B | 80,000 | 21,600 | 0.27 | 1 | 80,000 | 21,600 |
| C | 50,000 | 8,500 | 0.17 | 5 | 0 | 0 |
| D | 45,000 | 10,800 | 0.24 | 2 | 10,000 | 2,400 |
| E | 55,000 | 9,900 | 0.18 | 4 | 0 | 0 |
Total investment = 60,000 + 80,000 + 10,000 = 150,000
Total NPV = 12,000 + 21,600 + 2,400 = GH¢36,000
(B). The combination to maximise total NPV is found by identifying possible combinations of investments within the GH¢150,000 investment limit and calculating the total NPV from that combination.
| Investments | Capital investment | Total NPV |
|---|---|---|
| GH¢ | GH¢ | |
| A + B | (60,000 + 80,000) | 140,000 |
| C + D + E | (50,000 + 45,000 + 55,000) | 150,000 |
| B + D | (80,000 + 45,000) | 125,000 |
(B + D) is clearly better than (B + C) or (B + E).
Conclusion:
If the projects are indivisible, the combination of investments to maximise total NPV is investment in A and B.
- Topic: Capital rationing
- Uploader: Samuel Duah