Competing for the Firm\'s Fixed

Competing for the Firm's Fixed Capital Budget

Introducing the Situation

In order to further increase their revenues, organizations strive to identify, develop and implement the most adequate investment decisions that will be beneficial from numerous standpoints, such as an increase in financial outcome or in shareholder value. Yet, in most cases, the manager is presented with more than one alternative investment possibilities and has to employ various techniques to make the most adequate decision. Galaxy Satellite Co. is currently found in such an instance and it has to decide on which of the four available investment opportunities it should bet its $10,000,000 fixed capital budget. The table below reveals the financial characteristics of each four alternatives:

Project

Initial Investment

IRR

PV of Inflows at 20%

A

$3,000,000

21%

$3,050,000

B

9,000,000

25%

$9,320,000

C

1,000,000

24%

$1,060,000

D

7,000,000

23%

$7,350,000

In order to make the most suitable decision, it is necessary to assess the four investment opportunities through the lenses of the Net Present Value and the Internal Rate of Return.

2. Net Present Value

The Net Present Value represents the difference between positive and negative cash flows, otherwise put it is the result of extracting the outflows from inflows. A project is generally accepted when its NPV is positive, meaning as such that its cash flows will be positive. If one has to choose between more projects with positive net present values, the choice falls on the project with the largest value of the NPV, as this will be the most profitable endeavor (Investopedia, 2009).

Since the situation at Galaxy Satellite Co. already reveals the NP, the NPV can be identified by subtracting the value of the initial investment from its present value, or:

Net Present Value = Present Value -- Initial Investment

Net Present Value for project A = $3,050,000 -- $3,000,000 = $50,000

Net Present Value for project B = $9,320,000 -- $9,000,000 = $320,000

Net Present Value for project C = $1,060,000 -- $1,000,000 = $60,000

Net Present Value for project D = $7,350,000 -- $7,000,000 = $350,000

Based on the calculation of the net present value, the most suitable investment alternative at this stage is revealed as being project D.

3. Internal Rate of Return

The internal rate of return is used by economists and investors to identify the expected financial outcome of a given project. It is generally accepted that the final value of the internal return will vary from the initial calculations, but it is still relevant as the proportions in modifications will tend to remain relatively constant. The internal rate of return can be perceived similarly to the growth rate a project is expected to return and given this situation, the project with the highest IRR will be the one to be selected by the organization (Investopedia, 2009).

Internal rates of return for the four alternative investment projects are: project A -- 21%, project B -- 25%, project C -- 24% and project D -- 23%. Based on this measured rates, the most desirable course of action for Galaxy Satellite Co. is investment project B, with the highest IRR of 25%.

4. The Decision