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Investment Opportunity Schedule (IOS)

By Yuriy Smirnov Ph.D.

Definition

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.

Example

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

Making an investment opportunity schedule involves two easy steps.

  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.

Investment opportunity schedule

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.

Optimal capital budget

The optimal capital budget occurs when the IRR curve intersects the MCC curve. A company will maximize shareholder value if such an amount of additional capital is raised and invested.