Principles of Managerial Finance

CHAPTER 10 Risk and Refinements in Capital Budgeting 449

with the highest overall present value.This is the same as maximizing net present

value, in which the entire budget is viewed as the total initial investment. Any

portion of the firm’s budget that is not used does not increase the firm’s value. At

best, the unused money can be invested in marketable securities or returned to the

owners in the form of cash dividends. In either case, the wealth of the owners is

not likely to be enhanced.

EXAMPLE The group of projects described in the preceding example is ranked in Table 10.5

on the basis of IRRs. The present value of the cash inflows associated with the pro-

jects is also included in the table. Projects B, C, and E, which together require

$230,000, yield a present value of $336,000. However, if projects B, C, and A

were implemented, the total budget of $250,000 would be used, and the present

value of the cash inflows would be $357,000. This is greater than the return

expected from selecting the projects on the basis of the highest IRRs. Implementing

0 100 200 250 300 400 500

230

Total Investment ($000)

20% B

C

E

A

F

D

10%

IRR

Budget

Constraint

Cost of

Capital

IOS

FIGURE 10.4

Investment
Opportunities Schedule
Investment opportunities
schedule (IOS) for Tate
Company projects

TABLE 10.5 Rankings for Tate Company

Projects

Initial Present value of

Project investment IRR inflows at 10%

B$ 1 70,000 20% $112,000

C 100,000 16 145,000

E 60,000 15 79,000

A 80,000 12 100,000

F 110,000 11 126,500

D 40,000 8 36,000

Cutoff point

(IRR10%)