

Financial
Management MGT201
VU
Lesson
12
CAPITAL
RATIONING AND INTERPRETATION OF IRR AND
NPV WITH LIMITED
CAPITAL.
Learning
Objective:
After
going through this lecture,
you would be able to have an
understanding of the following
topic
·
Capital
Rationing
·
IRR
and NPV interpretation with
limited capital
In
this lecture, we would
discuss the practical side of
capital budgeting addressing the
problem of
allocating
your money among the different possible
projects, where the amount of money to invest
is
limited.
Companies
ration their capital and investments
among different opportunities. Similarly,
countries
use
rationing. For example, some
countries ration food. Capital
Rationing provide practical
basis to the
capital
budgeting because the decision of
capital budgeting are made
within limited financial
resources
of
the company in real life
situations.
Here,
the investment in real assets
would be discussed. It is mentioned
earlier that real assets
have
cash
flows associated with them.
Theses cash flows would be
discounted to the present and calculate
the
NPV
of the project. If, the NPV
>0, it will benefit the
organization. If the company invest in the
project
with
positive NPV it will bring
value to the company and result in
maximization of shareholders'
wealth.
As
we studied in previous lectures
how we could estimate the
after tax cash flows.
The
Importance
of good Cash Flow forecasts
and accurate Proforma Cash
Flow Statement
Net
Aftertax Cash Flows = Net
Operating Income + Depreciation +
Tax Savings from Depreciation
+
Net
Working Capital + Other Cash
Flows
Other
Cash Flows:
Include Opportunity Costs and
Externalities but Exclude Sunken
Costs
In
capital rationing the most
important criterion, which we
are using to decide whether to
invest
in
a projector not is the NPV.
The second important
criterion, which would be
used, is the IRR. There
is
a
new criterion which we look
at in capital rationing is percent budget
utilization. In other words,
what
percentage
of the total money available to
invest are you mobilizing?
It is important to mobilize as
much
money as possible in the projects on which
IRR is greater then risk
free rate if return because
you
want
to maximize the return on your
portfolio.
We
have study about certain special
situations, which cause
complexities in calculating
IRR
using
NPV equation. Multiple IRR
arises when there is more then
one sign changes in cash
flow
diagram.
In such situations, avoid
using NPV equation to calculate the
IRR because it would not
provide
the
correct result. To get the correct answer we
should use Modified IRR. In
this, you separate
the
Incoming
and Outgoing Cash Flows at
each period in time.
Discount all the outflows to the
present and
compound
all the Inflows to the termination date.
Assume reinvestment at a Cost of
Capital or Discount
Factor
(or Required Return) such as
the risk free interest rate.
MIRR
is that discount rate which
equates the future value of
cash inflows to the present
value of
cash
out flows. We use Common
Life or EAA Approach to adjust NPV of
projects with different
lives.
Now,
we discuss the capital rationing
and see that how the
context of problem changes
with
budget
constraint.
Until
now, we are discussing about
the ideal case with no
budget constraint. Practically,
money
is
in short supply & it is only that
much money that a company
has to spend in different
projects.
Therefore,
we need to change our analysis in
order to take into account
the limited resources like
money
in
making the investment decisions.
Now,
first thing to know who is
responsible for the decisions relating to
capital budgeting and
capital
rationing.
Generally, the investment decision
making is divided in accordance
with the size of the
investment
and criticality of the
investments.
Mandatory
(Critical & Necessary for
Business and Legal):
CEO
Discretionary
(R&D, Growth Projects) Investments: Junior
Mgmt or division
heads
Reasons
for Capital
Rationing:
What
are the reasons because of
which you do not invest in a
project which provide you
highest
return?
There are situations in
which after calculating the
IRR's and NPV's of different projects
you are
forced
not to invest in the best
project. Some reasons
are
1.
The best project may have a
very high initial investment
and you may not have that
money. So, you
are
forced to reject that
project as an option.
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Financial
Management MGT201
VU
2.
The company does not have the human
resource, knowledge, or talent,
which is required to
undertake
the
project. The project might
have high NPV but if you
cannot manage it, you are
forced not to invest
in
that project.
3.
The companies have the prevailing
fear of debt. In case of
Muslim countries, there is a major issue
of
"Riba"
(interest) among Muslim investors and the
companies due to this religious
constraint choose not
to
borrow money. That is the
reason that in many Muslim
countries capital rationing has an
ethical
bases
attach to it. Usually, the investors in
these countries invest in the equity
based investments as it
has
a risk of profit or loss in
that kind of investment. We
will discuss this topic in
the upcoming lectures.
Now,
it is important from you to
remember that companies have
different constraints, which
keep
them from investing in the best projects.
The fear of debt is
justified because when we
discuss
about
the risk in upcoming lectures you
find out that when a
company takes on debt its
future cash flows
become
more risky. Therefore, there is a
possibility of default due to which there
is a fear of debt.
These
are
various reasons due to which company
decides not to invest in the
project with the highest NPV
and
some
of them involve capital rationing
decisions as the following example
shows.
Example:
There
are 4 Projects (mutually
exclusive real asset projects) to
choose from. Total budget
is
Rs.1,
000
Project
Io=Investment
(Rs) IRR
NPV(Rs)
A:
200
40%
300
B:
100
40%
300
C:
300
35%
200
D:
800
30%
600
Which
3 projects you will choose
from the above 4 real asset
projects?
We
cannot pick all 4 Projects
because the Budget
Constraint is 1000 and the total
investment in
all
3 Projects is 1400 (=200+100+300+800).we
have to go through capital rationing
process & choose
from
among these 4 different projects. We have
some options, which are as
follows.
Option
1:
If
we pick Projects A, B, & C then we
have to consider what will be the
combined NPV of these
projects
and what average IRR will be
of this portfolio or combination of
projects. Finally, we have to
look
an interesting parameter for
capital rationing which is
what percentage of total
budget available is
being
utilized if we invest in these
projects.
Budget
Utilization = 200+100+300 = 600
(out of 1000)
Total
NPV of three projects = 300+300+200 =
800
Simple
Average IRR = 38% =
(40+40+35)/3 Nonweighted
38%
seems to be attractive IRR.
NPV of 800 looks good
relatively to the size of investments.
Finally,
we
look at percent budget utilization and
for this option
Budget
Utilization = 200+100+300 =
600
This
option is utilizing 60% of
total budget.
Now
we repeat the same practice for the
other options available to
us
Option
2:
Pick Projects A and D
because they have the highest
NPV's.
Budget
Utilization = 200+800 =
1000
Total
NPV = 300+600 = 900
Average
IRR = 35%
Option
3: Pick
Projects B and D because
they have the highest
NPV's.
Budget
Utilization = 100+800 =
900
Total
NPV = 300+600 = 900
Average
IRR = 35%
Conclusion
Summary:
Budget
Utilization
NPV
Avg
IRR
Option
1
Rs.600
(60%)
Rs.800
38%
Option
2
Rs.1000
(100%)
Rs.900
35%
Option
3
Rs.900
(90%)
Rs.900
35%
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Financial
Management MGT201
VU
It
is clear from the summery that option 2
is best option. It carries the
highest NPV which is
Rs
900
and it also has the highest budget
utilization at IRR of roughly 35
%.
Why
we not choose option 1:
Option
no 1 has the highest IRR of 38%
but the problem is that in
option 1 our NPV is not
the
highest,
rather, it is lower than the
option 2 and 3.
Secondly,
Budget utilization is only
60% and the 40% of the money
available for investment
is
wasted
and is lying idle. What will
you do with this money? The
idle money available in
company
should
earn some return on it. If
you do not have the attractive
project to invest in, you
are forced to
keep
it in a bank account that
will yield 9 to 10 percent. So, the
percent of budget utilize by
any
portfolio
is very important as it should be as
close to 100 % as possible.
Thus,
we conclude on the basis f maximum NPV
and maximum budget utilization
criterion that option
2nd is the
best.
3
Types of Problems in Capital
Rationing:
1.
Size
Difference of cash
flows
2.
Timing Difference of cash
flows
3.
Different (or Unequal) Lives
of different projects:
We
have discussed the problem of different
lives of the projects in previous
lectures.
Size
Difference (in Investment
Outlay):
The
differences in initial investment
(or outlay) means different
extend of budget
utilization.
We
compare the projects one with small
cash flows taking place at
regular interval and the
other project
has
large cash flows taking
place at different point in time. If
two projects have different cash
flows,
where
do you invest the unutilized
money or leftover portion of the budget?
Money that is not
generating
a good return is being
wasted and eaten up by
Inflation!
Example:
Budget
Size is Rs 1,500
Two
projects are
Project
A
Cash
Flows: Io= Rs200, Yr 1 = +
Rs300
·
NPV = Rs 73 (at
i=10%)
IRR
= 50%
Project
B
Cash
Flows: Io= Rs1, 500, Yr 1 =
+ Rs 1,900
·
NPV = Rs 227 (at
i=10%) IRR = 27%
If
we compare two projects the projects A
has higher IRR bit we do
not make our decision
on
IRR
because as it is mentioned earlier
that the most important
criterion would be
NPV.
Project
B has a highest NPV.
Therefore, we choose Project
B.IRR is lower because you
are receiving
the
large cash flow at the later
point in time in comparison to the
project A.
Timing
Difference Problems:
A
good project might suffer
from a lower IRR even though
its NPV is higher. It
receives its
larger
cash flows later in
time.
Example:
Budget
= Rs 2,500
Project
A Cash Flows: Io= Rs1,
000, Yr1=+Rs100, Yr2=+Rs200,
Yr3=+Rs2,000 (late
large
cash flow)
NPV
= + Rs 758 (at i=10%) IRR =
35%
Project
B Cash Flows: Io= Rs1,
000, Yr1=+650, Yr2=Rs650,
Yr3=Rs 650 (Annuity)
NPV
= + Rs 616 (at i=10%) IRR =
43%
We
would choose Project A on the
basis NPV Criteria.
Different
Lives Problem:
In
comparing two projects or Assets
(i.e. Sewing Machines or
Printing Machines) with
different
lives:
Disadvantage
of project with very long
life:
Does
not give you the opportunity
(or option) to replace the equipment
quickly in order to keep
pace
with technology, better quality,
and lower costs
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Financial
Management MGT201
VU
Disadvantage
of project with very short
life:
Your
money will have to be reinvested in some
other project with an
uncertain NPV and return so
it
is
risky. If a good project is
not available, the money
will earn only a minimal
return at the risk
free
interest
rate.
You
should use Common Life and EAA
Techniques to quantitatively compare
such Projects. You
have
studied this topic in detail
in the previous lecture.
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