Firms investment capital is usually have limits that prevent a company on accepting and investing in every attractive project. Firm's goal is to select the best possible investment package of projects that is within company's resources. That is called Capital Rationing.
Supposedly you have five projects. All of them have attractive net present value, IRR, and profitability index.
- Net present value (NPV)
rule recognizes the time value of money: the fact that a dollar today is worth more than a dollar tomorrow. Today's dollar can be invested right now and start earning interest right now. Net present value calculates net present value of your investment.
- Internal Rate of Return (IRR)
. The internal rate of return is defined as the discount rate that makes NPV (net present value) equal to zero. The IRR (internal rate of return) rule is to accept a project if the IRR is higher than opportunity cost of capital. If it is than it means that the project has positive NPV.
- Profitability Index
. The ration of net present value per dollar of initial outlay (investment). You can also easily calculate Benefit-Cost Ration, which is a ratio of Present Value (PV) to initial outlay, by adding 1.00 to Profitability Index. However, the ranking of projects' attractiveness will not change.
You have five good investment opportunities, however, you can invest only fixed amount of money each year, which in our case it is $35,000. Below is an example:
Project 1: Initial Investment - $10,000; NPV - 15,000; IRR - 20%; Profitability Index - 1.50
Project 2: Initial Investment - $20,000; NPV - 25,000; IRR - 22%; Profitability Index - 1.25
Project 3: Initial Investment - $15,000; NPV - 20,000; IRR - 22%; Profitability Index - 1.33
Project 4: Initial Investment - $35,000; NPV - 50,000; IRR - 25%; Profitability Index - 1.43
Project 5: Initial Investment - $40,000; NPV - 80,000; IRR - 26%; Profitability Index - 2.00
From the first look Project 4 and Project 5 seem like very attractive opportunities. However, if you invest in Project 4, you will not be able to invest in anything else this year. But, what if you will accept Project 2 and Project 3? It may give you higher NPV, IRR and / or Profitability Index as a package. Or it may have lower NPV, IRR and Profitability index then Project 4; however, they may produce enough cash flows in the coming year to enable you to accept Project 5 next year. Then, when you consider Project 2, Project 3, and Project 5 together, it will give you higher total net present value, internal rate of return and profitability ration.
A firm needs a tool to analyze all possible investment combinations and produce best possible package to invest in.
This model is made to solve capital budgeting problems for up to five projects when resources are limited.
I develop financial model that takes into consideration all 120 possible outcomes (probability of 5 projects) and gives an answer which package is the best. The model will provide step by step guide on how to develop correct cash flow of each of five projects and calculates the rest for you. Useful links 1031 Tax Exchange
Specialists in commercial real estate, 1031 Tax Exchange, land development, and water procurement & distribution services
Expert witness and Forensic Accounting service available to businesses nationwide.