7.21 : Choosing Between Projects: Limited Resources

In capital budgeting, various methods can be employed when choosing between projects with limited resources, with net present value or NPV being one of the most common.

NPV helps evaluate the total value each project will add to the company, measured in terms of their present value.

For example, consider a chocolate manufacturing company with a budget of one hundred thousand dollars for investment and two projects under consideration.

Project A requires an initial investment of eighty thousand dollars and expects cash inflows of one hundred thirty thousand dollars over five years.

Project B requires an initial investment of fifty thousand dollars with expected cash inflows of one hundred and twenty thousand dollars over five years.

NPV is calculated considering a ten percent discount rate.

NPV for Project A is nineteen thousand dollars, and NPV for Project B is approximately forty-one thousand dollars.

Despite the higher initial cost and total inflows of Project A, Project B is more beneficial with a higher NPV.

Therefore, under limited capital, Project B would be chosen as it offers a higher return on investment after considering the time value of money.

This method ensures the best use of scarce resources by maximizing economic value.