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CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing

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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 After-tax 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 Non-weighted
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
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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 un-utilized 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
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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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Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios