Managerial Economics

Optimal Capital Budget

Investment Opportunity Schedule

Lesley Allen D. Kabigting

Ms. Geraldine Lim, MBA

The investment opportunity schedule is a list of projects arranged in descending order of internal rate
of return.
 As the main objective of a company’s management is to maximize shareholder value, projects with the
highest expected return should be undertaken first.
During each financial year, a company may have many investment opportunities, but the more projects
undertaken, the more additional capital has to be raised. In turn, raising additional capital is quite
complicated for several reasons.

1. Marginal cost of capital. The more additional capital a company is raising, the higher its cost will be, and
the higher the cost of capital, the lower the net present value (NPV) of a project.

2. Capital markets limits. A company cannot raise an infinite amount of capital. In the real world, a limited
number of investors will be found, and a finite amount of capital can be raised in a certain period of
time.
Preparing an investment opportunity schedule allows prioritization of projects to be undertaken, which
maximizes shareholder value.

The management of a company is considering seven projects of the same risk to undertake in the next
financial year.

How to make an investment opportunity schedule

1. Arrange projects by the internal rate of return (IRR) from highest to lowest.
2. Calculate the cumulative cost (total need in additional capital).

As the net present value is the primary screening criterion, a company should accept all projects
having positive NPV. In turn, a project has a positive NPV if its IRR is higher than the cost of
capital. For example, if a company is able to raise $30,000,000 at a 12.00% interest rate, Project
D and Project A should be rejected.

If a company can raise only $5,000,000 at a 12.00% interest rate, the highest priority projects
should be undertaken, i.e., Project B and Project E.

As we can see, the investment opportunity schedule is a powerful tool in capital budgeting
decisions, which helps maximize shareholder value.
Graph

An investment opportunity schedule plotted on a graph shows how much money a company can
invest in projects of different internal rates of return. An example is shown in the figure below.

Marginal cost of capital and optimal capital budget

The investment opportunity schedule and marginal cost of capital (MCC) are very important
concepts in capital budgeting decision-making. The MCC and IRR curves should be plotted in the
same graph as illustrated in the figure below.

Source: http://financialmanagementpro.com/investment-opportunity-schedule/