Submitted By hasurasharma
Chapter 3. The Optimal Capital Budget
Up this point, we have discussed some of the issues regarding a firm’s cost of capital and capital budgeting decisions. In the process, we have looked at some of the techniques a financial manager can use in identifying the cost of various forms of capital and choosing projects that are “profitable” to the firm. Based on our earlier discussions, we know there is a significant relationship between a firm’s cost of capital and capital budgeting decisions. In order to decide whether a project is desirable, a financial manager uses the cost of capital the firm faces to determine the project’s net present value; or compare the project’s IRR with the cost of capital. In addition, we also know that the cost of capital a firm faces might not be constant (i.e. the firm’s MCC schedule might experience several break points). In that case, how does a firm decide what is the appropriate cost of capital? And how does it decide the optimal budget it needs for project investments? In order to answer those questions, we need to first look at a firm’s investment opportunity schedule (IOS).
The Investment Opportunity Schedule (IOS)
The concept behind the IOS is very similar to that of the MCC schedule. The MCC schedule represents the cost of capital faced by the firm (ranking from the cheapest to the most expensive) while the IOS represents the projects that are available to the firm (ranking from the most desirable to the least desirable).
In order to construct the IOS, the firm needs to first estimate the IRR of each of the project it is considering. Once that is accomplished, the financial manager can plot the IOS, which is a chart of the IRRs of the firm’s projects arranged from the highest IRR to the lowest IRR.
Example: Microsoft is interested in five independent projects, and the financial information regarding those projects is…...