Question

Two investment opportunities have positive net present values. Investment A's net present value amounts to $40,000, while B's is only $30,000. Does this mean that A is the better investment opportunity? Explain.

***I have already checked existing answers and I hope to get better ideas regarding the matter. Thank you.

Answer 1

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As per NPV criteria, project with higher NPV should be selected. But NPV ignores the volume of initial investment. When accepting project basis NPV it is assumed that idle funds would be invested at the cost of capital. Thus project with higher NPV is preferred. Let me explain you this with the help of example.

Suppose investment in Project A is 200,000 whereas investment in project B is 100,000. Then we can say that 200,000 is generating NPV of 40,000 only whereas 100,000 is generating NPV of 30,000 which seems that rate of return on Project B is better. But what about the remaining 100,000 (200,000 - 100,000). It is assumed that this 100,000 would be invested at the cost of capital which would generate Nil NPV. Thus Total NPV of Project B + Investment of remaining funds = 100,000 + 0 = 100,000.

There may be another investment option available with Project B with the funds available. In that case Capital rationing should be applied.Capital rationing means taking NPV of different options which are available.