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Corporate Finance

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Corporate Finance ­FIN 622
Lesson 14
Following topics will be discussed in this hand out:
Single period capital rationing
Multi-period capital rationing
Linear programming
When limits are placed on the availability of finance for positive NPV projects for one year only and capital
is freely available in all the rests of periods.
There are some additional assumptions in single period rationing which are very important to consider here:
If a firm does not undertake a project `now' ­ the period of capital scarcity, the opportunity is lost.
In other words, the project cannot be deferred until the capital is available.
ii)  The outcome of each project is known with certainty so that the choice between the projects is not
affected by considerations of risk.
iii)  The projects are divisible ­ it means that we can undertake 50% of project A and 50% of project B.
The basic approach will be to rank the projects in such a way that NPV can be maximized from the use of
available finances.
Ranking the projects using NPV will be incorrect in this scenario because NPV basis will lead to select the
`big' projects, each of which has a high individual NPV but which have a lower NPV than a large number of
smaller projects with lower individual NPVs. Therefore, ranking should be made in terms of Profitability
There are some issues with the PI method as well and should be outlined. This approach would only be
feasible if projects are divisible. If projects are not divisible, which is normally the case in reality; a decision
should be made by considering the absolute NPV of all possible combinations of all positive projects within
the constraint of limited capital.
This method is of little use when project have different cash flow patterns.
PI method ignores the absolute size of individual projects. A project with a high index might be very small
and therefore only generate a small NPV.
When capital is in limited availability in more than one period and selection of projects cannot be made by
ranking projects according to PI, this situation is known as multi-period capital rationing.
Capital constraints are imposed in more than one period to restrict the acceptance of positive NPV projects.
Other techniques like linear programming tools can be used.
In mathematics, linear programming (LP) problems are optimization problems in which the objective
function and the constraints are all linear.
Open problems
·  Does LP admit a polynomial algorithm in the real number (unit cost) model of computation?
·  Does LP admit a strongly polynomial algorithm?
·  Does LP admit a strongly polynomial algorithm to find a strictly complementary solution?
·  Does LP admit a (strongly or weakly) polynomial pivot algorithm (may be a non-simplex pivot
algorithm, e.g., a criss-cross or arrangement method)?
·  Is the polynomial diameter conjecture true for polyhedral graphs?
·  Does LP admit a (strongly or weakly) polynomial simplex pivot algorithm?
·  Is the linear diameter (Hirsch) conjecture true for polyhedral graphs?
Here we will discuss the graphical approach to LP. This involves only two variables and if there are more
than two variables then simplex method is used.
When we are confronted with TWO projects (only) we can use graphical method to select the one best fit
First step is to define the variables or project by assigning them symbols like x & y, a & b etc.
The second step is the key issue where we establish the constraints like availability of capital in period 1, 2
and so on. For example, if we have two projects x and y and project x need 30 million of investment and
project y requires 25 million of investment and we have only 40 million available, then the constraint can be
expressed as:
Corporate Finance ­FIN 622
30x + 25y <= 40
Last step is to form an objective function. The objective function is to maximize the investment return.
When we have translated the constraints and objective function in equation we plot these on a graph to
work out the feasible solution.
Table of Contents:
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk