In capital budgeting, selecting positive NPV projects adds value to a company. Although businesses ideally pursue all positive NPV projects, managers often face budget constraints that limit the amount of capital they can invest within a given period. In such cases, the goal is to maximize the total NPV while staying within budget limits.
For example, a chocolate manufacturing company has a $100,000 budget and two projects under consideration. Project A requires an investment of $80,000, with expected cash inflows of $130,000 over five years ($26000 per annum). Project B requires a $50,000 investment with projected inflows of $120,000 over the same period ($24000 per annum). Using a 10% discount rate, the NPV for Project A is $18,560, while Project B's NPV is $40,979.
Despite Project A's higher inflows, Project B is more beneficial, offering a higher NPV. Choosing Project B ensures the best use of limited resources by maximizing return on investment while accounting for the time value of money. This approach helps companies optimize capital allocation and achieve the greatest economic value.
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