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Issues in Capital Budgeting II

Issues in Capital Budgeting II. FINA 4463 (Chapter 12 in text). Capital Rationing. Capital Rationing. Usual assumption is that firm should accept all NPV>0- projects What if firm has a number of NPV>0 projects, but doe not have resources to take on all of them?

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Issues in Capital Budgeting II

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  1. Issues in Capital Budgeting II FINA 4463 (Chapter 12 in text)

  2. Capital Rationing

  3. Capital Rationing • Usual assumption is that firm should accept all NPV>0- projects • What if firm has a number of NPV>0 projects, but doe not have resources to take on all of them? • This is situation of capital rationing • Limited amount of capital to invest • Must decide how to best invest the limited resources

  4. Sources of Rationing Two types of capital rationing: • Soft rationing: capital constraint imposed internally by the firm • Head office may assign a budget to each division • If soft rationing is leading to a division foregoing many NPV>0 projects, then the budget should be changed

  5. Hard rationing: capital constraint imposed on firm by the capital markets • Firm has limited internal cash, cannot borrow and cannot (or will not) issue new equity • In a perfect world, there would never be externally imposed capital constraints • In perfect world, firm could simply announce it had a good project to invest in, show investors the risk and return projections, and then investors would be willing to invest equity in/lend to the project

  6. However, the world is not perfect. • There are several reasons that firms may be unable or unwilling to bring in external financing for a good projects: • Firm and investors may disagree on value of project • Management may lack creditability • Especially true for smaller, newer firms, or firms with poor records • Flotation Costs • It costs money to issue new shares/bonds • The additional cost may make raising money to finance a project not worthwhile • Flotation costs are higher for smaller issues, so small firms are affected the most (also higher for equity issues compared to debt).

  7. 3. Underpriced shares • Firms shares may be trading below their true value • Management knows that the shares are undervalued (management has better info about firm than market = asymmetric information) • Selling shares to raise funds to finance a project means that shareholders get a good project, but are selling part of the firm at a discount • In some cases the project will not be worthwhile and firm will skip project • Biggest effect on firms with high degree of asymmetric information (complicated firms, new firms, firms with few analysts following them)

  8. Note: firms can benefit from having cash on hand available. • Can fund NPV>0 projects that without accessing markets • Do not have to skip a good projects because of reasons above • Assuming a firm is subject to capital rationing, how should it solve for the optimal investment strategy, given the constraint?

  9. Example: • Firm has $10 million available for investment, 3 potential projects • Simply choosing highest NPV means choose A • Uses up total budget • NPV = 21.4

  10. However you could take B and C instead • Uses up entire budget • Total NPV = 28 • B and C is the better choice • Best combination of projects is fairly obvious in this case, but may not be in more complicated situations

  11. Solving for Optimal Decision in Capital Rationing Problems • Common way to approach capital rationing problem is to use the profitability index • PI shows which projects give “most value for your money” • PI = value of project per dollar invested • Choose project with highest PI, and keep choosing projects until your budget runs out

  12. From previous example: • Solution by PI: choose B and C

  13. Problems with Profitability Index • If projects chosen via PI do not exhaust the budget, you may not get the optimal solution Example • Required return = 10%, budget constraint = $100

  14. Problems with Profitability Index • PI says take first two projects for total NPV = 2.27 + 1.36 = 3.63 • This leaves $90 of budget unspent • Better to take third project by itself, for total NPV = 9.09 • Reason: PI has difficulty in comparing projects of different sizes • Note: As long as your answer using PI uses up entire budget the NPV should be the maximum possible

  15. Problems with Profitability Index • PI also runs into problems if there is more than one constraint faced by firm • Projects are mutually exclusive (if you take one you cannot take the other) • Projects are dependant (you can only take on one project, if you have already taken another) • Budget constraints in more than one period • Etc. • The usual approach to capital rationing situations is to solve for the optimal investment using optimization software on a computer • Maximize an objective function subject to certain constraints • Can use “Solver” on Excel

  16. Investments of Unequal Lives

  17. Investments of Unequal Lives • When comparing mutually exclusive alternatives, NPV does not always give correct choice as to the best alternative if they are of different lengths • e.g. comparing Machine A to Machine B where B costs more but lasts longer • NPV does not take into account the different lifespans of the projects

  18. Investments of Unequal Lives Example • Machine A costs $10,000 and increase profits by $5000/year. It lasts 6 years. • Machine B costs $5,500 and increases profits by $5000/year. It lasts 3 years • Discount rate = 10%

  19. A has highest NPV • A is best choice if this is a “one time deal” • If you will only buy a machine once and never replace it • More commonly, machines have to be replaced as they wear out • If replacement of machines as they wear out is relevant, there are two methods to correctly compare the alternatives • Project Replication • Equivalent Annuities

  20. Project Replication • Find a common multiple of the two life lengths • Use this as total project length for both alternatives, where each alternative is repeated the appropriate number of times • Calculate NPV over this common time frame and compare Equivalent Annuities • Equate the NPV of each alternative to an annuity • The length of the annuity equals the life of the project • Solve for annuity payment that would give the same NPV • The annuity payment represents the value per year created by the project • Since projects are now on a common time frame (per year), can simply compare

  21. Optimal Replacement Time • It may sometimes pay to replace a machine before the end of its “natural” life • May happen if: • Better machine becomes available • Salvage value is decreasing as machine ages • Machine becomes more expensive to operate or less efficient overtime • Optimal time to replace a machine is just a special case of comparing projects of unequal lives

  22. Example: • A machine you always need for your production process • Lasts a maximum of three years before replacement needed • It becomes less efficient over time • When replaced, you will replace with an identical (but new) machine • How often should you replace? • Discount rate=10%

  23. (example continued) • To solve, compare 3 projects of unequal lives: replace in year 1 vs. replace in year 2 vs. replace in year 3

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