Capital Rationing and the Unsigned Contract
You are operations director for a mid-sized manufacturer. The capital budget for next year is capped at $500,000. Four independent projects have been submitted; none can be partially funded, and all must be decided now. Project A, an automation cell, costs $200,000 and has an NPV of $60,000. Project B, a warehouse management system, costs $300,000 and has an NPV of $75,000. Project C, fleet telematics, costs $250,000 and has an NPV of $55,000. Project D, a safety retrofit, costs $150,000 and has an NPV of $35,000. Finance uses a 10% discount rate and ranks by profitability index. The CFO's draft memo recommends A and D because they have the two highest indexes and fit the budget. The safety director says D is non-negotiable for compliance. The sales VP says B is needed to support a new contract, though the contract is not signed. Last year's forecast missed by 18%, and the board has asked for a risk-adjusted view.
1. Evaluate the CFO's recommendation. Calculate the feasible combinations and recommend a portfolio, showing your reasoning.
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The profitability indexes are A $60k/$200k = 0.30, B $75k/$300k = 0.25, C $55k/$250k = 0.22, and D $35k/$150k = 0.23. Ranking by PI and funding greedily gives A then D: cost $350k, NPV $95k, with $150k left over that cannot fund B or C. That is the CFO's error: PI ranking assumes divisible projects and ignores unused capital.
The feasible combinations are:
| Portfolio | Cost | NPV |
|---|---|---|
| A + B | $500k | $135k |
| A + C | $450k | $115k |
| B + D | $450k | $110k |
| A + D | $350k | $95k |
| C + D | $400k | $90k |
A + B maximizes NPV and uses the full budget, beating the CFO plan by $40k. My recommendation is A + B if D is not legally mandatory. If D truly is non-negotiable, the best feasible portfolio containing D is B + D at $110k, not A + D; A + D leaves $150k stranded and gives up $15k of NPV. If B's contract is too uncertain, the compliance-constrained alternative is A + D plus a request to fund D from a compliance or operating budget outside the capital cap. I would not silently drop a legal requirement to make the spreadsheet work.
2. The sales VP argues B should be included because of the unsigned contract. How should you treat that in the analysis, and what sensitivity or condition would you attach?
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I would treat the unsigned contract as contingent, not as base-case revenue. The first step is to ask finance to separate B's value into two parts: the warehouse-management benefits that exist without the contract, and the incremental NPV that depends on the contract. Only the first belongs in the base case. The second belongs in a scenario or expected-value calculation, and even then only if there is credible probability evidence.
I would present three cases: no contract, contract signed, and probability-weighted expected NPV. If the contract risk wipes out more than the $20k NPV advantage that A + B has over A + C, then A + C becomes the better risk-adjusted choice. That threshold is useful in the conversation because it moves the debate from advocacy to a number.
Conditions for approving B: a signed contract or a binding letter of intent by a specified gate date; stage-gated spending so the full $300k is not committed before commercial confirmation; vendor cancellation and exit terms; and a defined fallback if the gate is missed. I would also consider whether B creates option value, such as a platform for later automation, but I would not count that as NPV without evidence. Finally, because last year's forecast missed by 18%, I would apply a conservative haircut to B's demand assumptions and document the sensitivity.