FIN 571 Week 5 Capital Budgeting Example

Fourteen Million Dollars and Five Good Projects: Ranking Cascade Ridge's Investments Under Capital Rationing, Matching Discount Rates to Risk and Why the Profitability Index Can Mislead

[Student Name]

University of Phoenix

FIN/571: Corporate Finance

Week 5 Assignment

[Instructor Name]

[Date]

Cascade Ridge Beverage, its projects and all figures are composites written for a model paper; methods and research findings come from the sources listed.

Cascade Ridge Beverage, the composite Bend, Oregon, brewer, has more good investment ideas than its owners will fund. The founding family, unwilling to dilute its control or borrow beyond its comfort, capped next year's capital spending at $14 million. Five projects compete for that money. When every project on the list adds value, the question becomes which combination adds the most, and the usual shortcuts do not always find it. This paper selects the portfolio.

The Five Projects

The canning line for non-alcoholic beer, analyzed in Week 2, costs $9 million. A taproom and restaurant in Portland's Pearl District costs $4.5 million. Solar panels and a heat recovery system for the brewhouse cost $3.2 million and cut energy bills under a fixed-price utility contract. Warehouse automation with a pallet-handling system costs $2.5 million and would cut forklift labor and damaged cases in the busy summer months. An expansion into Colorado, mostly marketing, sales staff and distributor support, costs $3 million.

Discount Rates by Risk

A single 9 percent rate for all five would tilt the choice toward the riskiest ideas. The finance team set rates by risk. The solar project, whose savings depend on known energy use and contracted prices, uses 7 percent. Warehouse automation and the canning line, extensions of existing operations with some market risk, use 9 and 10 percent. The taproom, exposed to restaurant competition and Portland's downtown recovery, uses 11 percent. The Colorado expansion, in a crowded market where the brand is unknown, uses 12 percent (Brealey et al., 2020).

The Results

At those rates, the canning line is worth about $7.9 million more than it costs, with a return near 24 percent. The taproom adds about $1.8 million, with an internal rate of return near 16 percent. Solar adds about $1.4 million at about 15 percent. Colorado adds about $1.2 million at about 18 percent. Warehouse automation adds about $0.6 million at about 13 percent. Every project clears its hurdle.

The Profitability Index

The profitability index divides the present value of future cash flows by the initial cost. The canning line's is about 1.88, solar's 1.44, the taproom's and Colorado's about 1.40 and warehouse automation's 1.24. Ranking by the index and funding from the top selects the canning line and solar, spending $12.2 million. The next projects, the taproom at $4.5 million and Colorado at $3 million, do not fit in the remaining $1.8 million, nor does warehouse automation. That portfolio creates about $9.3 million of value.

Searching All Combinations

Because projects cannot be built in fractions, the best choice comes from comparing every combination that fits the budget. The canning line plus the taproom spends $13.5 million and creates about $9.7 million, more than the index ranking. The canning line plus Colorado spends $12 million and creates about $9.1 million. Without the canning line, the four smaller projects together spend $13.2 million and create only about $5 million. The best portfolio is the canning line and the taproom. Lorie and Savage (1955) identified this problem decades ago: when funds are limited and projects are indivisible, ranking rules can fail, and only a comparison of feasible combinations guarantees the best result.

What Internal Rate of Return Would Have Done

Ranking by internal rate of return would pick the canning line first, then Colorado at 18 percent, spending $12 million and creating about $9.1 million, less than the best portfolio. It would also leave $2 million unspent, since nothing else on the list fits, which a combination search would have flagged immediately. A high rate on a small project can mislead when the goal is total value.

Risk in the Largest Project

Because the canning line dominates the portfolio, the team ran a simulation, drawing 10,000 combinations of non-alcoholic revenue growth, cannibalization and margin from ranges based on pilot data. The median net present value was about $7.5 million, and about 9 percent of trials produced a negative value, mostly when revenue growth stalled in years two and three. The project remains attractive, but the risk is real and concentrated in the early years, which supports staged marketing spending that can be cut if early sales disappoint.

Mutually Exclusive Choices Within a Project

The taproom itself came with a choice. A smaller taproom without a kitchen would cost $2.6 million, have a higher internal rate of return, about 19 percent, but add only about $1.2 million of value, because food sales drive longer visits and more beer sold per guest. Ranked by rate, the small version wins; ranked by value, the full restaurant wins. Under the budget, the small taproom would leave $2.4 million unused after the canning line, enough for warehouse automation, for a combined value of about $9.7 million, the same as the full taproom. With the two options tied, management chose the full restaurant for its brand value in Portland, a judgment the numbers leave open.

Post-Audits

The board also asked for a check on past forecasts. A review of the last five major projects found that revenue forecasts had averaged about 12 percent too high, mostly for new products. The finance team now applies a haircut of 10 percent to new-product revenue in base cases and compares results with forecasts one and three years after each investment.

What Practitioners Do

Graham and Harvey (2001) reported that discounted cash flow rules dominated at large companies, while payback remained common among smaller ones, and that many firms used a single company-wide discount rate even for projects of different risk. Cascade Ridge's risk-adjusted rates go beyond common practice, which matters most when projects differ as much as solar panels and a new state.

Delaying Rather Than Rejecting

Solar and Colorado are not lost. Solar's savings are steady and its panel prices have been falling, so delaying it a year costs about one year of savings, roughly $430,000, but it can be funded next year. Colorado's value depends on timing in a competitive market; waiting a year to see how non-alcoholic sales develop may even improve the decision.

What the Cap Costs

Without the cap, all five projects would add about $12.9 million of value. With it, the best portfolio adds about $9.7 million. The cap therefore costs the owners about $3.2 million this year, partly recoverable by delaying solar and Colorado. That is the price of avoiding more debt or new shareholders, a choice the family can now weigh in dollars.

Conclusion

Under a $14 million cap, Cascade Ridge should build the canning line and the Portland taproom, a portfolio worth about $9.7 million. Ranking by profitability index or internal rate of return would have chosen worse combinations. Risk-adjusted rates, a simulation of the largest project and an estimate of what the cap costs give the owners a clear basis for their decision.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of corporate finance (13th ed.). McGraw Hill.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Lorie, J. H., & Savage, L. J. (1955). Three problems in rationing capital. The Journal of Business, 28(4), 229-239. https://doi.org/10.1086/294081