1

Capital Rationing
Capital rationing occurs when a limit is placed
on the dollar size of the capital budget.
How to select: Select a set of projects with the
highest NPVs subject to the capital
constraint. Using NPV may preclude
accepting the highest ranked project in terms
of PI or IRR.
Capital Rationing: An Example
(Firms Cost of Capital = 12%)
Independent projects ranked according to
their IRRs:
Project Project Size IRR
E $20,000 21.0%
B 25,000 19.0
G 25,000 18.0
H 10,000 17.5
D 25,000 16.5
A 15,000 14.0
F 15,000 11.0
C 30,000 10.0
Capital Rationing Example (Continued)
No Capital Rationing - Only projects F and C
would be rejected. The firms capital budget would
be $120,000.
Capital Rationing - Suppose the capital budget is
constrained to be $80,000. Using the IRR
criterion, only projects E, B, G, and H, would be
accepted, even though projects D and A would
also add value to the firm. Also note, however,
that a theoretical optimum could be reached only
be evaluating all possible combinations of projects
in order to determine the portfolio of projects with
the highest NPV.
4
Ranking Problems
Size Disparity
Time Disparity
Unequal Life
5
Size Disparity
This occurs when we examine mutually
exclusive projects of unequal size.
Example: Consider the following cash
flows for one-year Project A and B, with
required rates of return of 10%.
Initial Outlay: A = $200 B = $1,500
Inflow: A = $300 B = $1,900
6
7
Project A Project B
NPV 72.73 227.28
PI 1.36 1.15
IRR 50% 27%
Ranking Conflict:
Using NPV, Project B is better;
Using PI and IRR, Project A is better.
Size Disparity
8
Which technique to use to select the better
project?
Use NPV whenever there is size disparity. If
there is no capital rationing, project with the
largest NPV will be selected. When capital
rationing exists, select set of projects with the
largest NPV.
Size Disparity
9
Time Disparity Problem
Time Disparity problems arise because of
differing reinvestment assumptions made
by the NPV and IRR decision criteria.
Cash flows reinvested at:
According to NPV: Required rate of return
According to IRR: IRR
10
Example: Consider two projects, A and B,
with initial outlay of $1,000, cost of capital
of 10%, and following cash flows in years
1, 2, and 3:
A: $100 $200 $2,000
B: $650 $650 $650
Time Disparity Problem
11
12
Project A Project B
NPV 758.83 616.45
PI 1.759 1.616
IRR 35% 43%
Ranking Conflict:
Using NPV, A is better
Using IRR, B is better
Which technique to use to select the superior project?:
Use NPV
Time Disparity Problem
13
Unequal Lives Problem
This occurs when we are comparing two
mutually exclusive projects with different
life spans.
To compare projects, we compute the
Equivalent Annual Annuity (EAA)
Mutually Exclusive Investments with Mutually Exclusive Investments with
Unequal Lives Unequal Lives
Suppose our firm is planning to
expand and we have to select 1 of
2 machines. They differ in terms
of economic life and capacity.
How do we decide which machine
to select?
The after-tax cash flows are:
Year Machine 1 Machine 2
0 (45,000) (45,000)
1 20,000 12,000
2 20,000 12,000
3 20,000 12,000
4 12,000
5 12,000
6 12,000
Assume a required return of 14%.
Step 1: Calculate NPV Step 1: Calculate NPV
NPV NPV11 = $1,432 = $1,432
NPV NPV22 = $1,664 = $1,664
So, does this mean #2 is better? So, does this mean #2 is better?
No! The two NPVs cant be compared! No! The two NPVs cant be compared!
Step 2: Equivalent Annual Step 2: Equivalent Annual
Annuity (EAA) method Annuity (EAA) method
If we assume that each project will be
replaced an infinite number of times in the
future, we can convert each NPV to an
annuity.
The projects EAAs can be compared to
determine which is the best project!
EAA: Simply divide the NPV by the PVIFA
for the projects original life.
EAA = NPV / (PVIFA i, n)
EAA = NPV / (PVIFA i, n) EAA = NPV / (PVIFA i, n)
EAA EAA11 = 1,432 / (PVIFA . = 1,432 / (PVIFA .14, 3 14, 3) )
= 1,432 / (2.3216) = 1,432 / (2.3216)
= $617 = $617
EAA EAA22 = 1,664 / (PVIFA = 1,664 / (PVIFA .14, 6 .14, 6) )
= 1,664 / (3.8887) = 1,664 / (3.8887)
= $428 = $428
What does this tell us? What does this tell us?
EAA1 = $617
EAA2 = $428
This tells us that:
NPV1 = annuity of $617 per year.
NPV2 = annuity of $428 per year.
So, weve reduced a problem with
different time horizons to a couple of
annuities.
Decision Rule: Select the highest EAA.
We would choose machine #1.
20
The Multinational Firm:
Capital-Budgeting
The key to success in capital-budgeting is finding
good projects. Finding new projects and correctly
evaluating them are key to the continued success of
firms.
For many companies, finding new projects involves
going overseas through joint ventures or strategic
alliances or establishing subsidiaries abroad.
Some companies generate > 50% of their revenues
from sales abroad.
Keown, Martin, Petty - Chapter 9 21
Modified IRR
Primary drawback of the IRR relative to the net
present value is the reinvestment rate assumption
made by the internal rate of return
Modified IRR allows the decision maker to directly
specify the appropriate reinvestment rate
MIRR> required rate of return, accept
MIRR< required rate of return, reject
Keown, Martin, Petty - Chapter 9 22
MIRR Example
Project having a 3yr. Life and a required rate of
return of 10% with the following cash flows:
FCFs FCFs
Initial
Outlay
-$6,000 Year 2 $3,000
Year 1 $2,000 Year 3 $4,000
Keown, Martin, Petty - Chapter 9 23
Step 1: Determine the PV of the projects cash
outflows. $6,000 is already at present.
Step 2: Determine the terminal value of the projects
free cash flows. To do this use the projects required
rate of return to calculate the FV of the projects three
cash flows of the projects cash outflows. They turn
out to be $2,420 +$3,300 + $4,000 = $9,720 for the
terminal value
MIRR Example
Keown, Martin, Petty - Chapter 9 24
Step 3: Determine the discount rate that equates to the
PV of the terminal value and the PV of the projects cash
outflows. MIRR= 17.446%. It is > required rate of return:
Accept
MIRR Example