Page 195 - DMGT521_PROJECT_MANAGEMENT

Project Management

Notes 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).

11.6.1 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 presented in the following table:

Table 11.1: Information of Financial and Independent Projects

Year Project 1 Project 2 Project 3 Project 4 Project 5
Initial Cost $250,000 $100,000 $100,000 $120,000 $200,000
IRR 34.54% 39.03% 33.87% 14.28% 16.41%
Payback 2.21 1.50 1.83 3.50 4.33

Using the IRR information above, we can arrange the projects from the highest IRR to the lowest
IRR as follows: Projects 2, 1, 3, 5 and 4. This information is used to plot the Microsoft’s IOS and it
is depicted below:
Figure 11.2: Depiction of Microsoft’s IOS
IRR

39.03%
34.54%
33.87%

16.41%
14.28%

New
Capital
100 350 450 650 770
From the IOS above, we know that if Microsoft decides to undertake all five projects, it will need
an investment budget of $770,000. However, Microsoft does not know if this is advisable because

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