EPJ3760 Construction Investments Lecture 9: November 2013

9.1 Capital Rationing 9.2 Project Selection

Definition Under capital rationing:
Capital rationing = limiting the size of the capital Select the group of projects with the highest combined NPV
budget possible within the capital constraint.

e.g. If the capital budget is limited to 1million, which

Possible reasons: projects should be selected? (Assume all projects are
1. Temporarily adverse market conditions indivisible and none are mutually exclusive)
2. Shortage of management capacity Project Initial PI NPV IRR
3. Intangible considerations: Outlay
dont want to increase debt A 200,000 2.4 280,000 62%
dont want to issue more stock B 200,000 2.3 260,000 49%
C 800,000 1.7 560,000 33%
Effect: D 300,000 1.3 90,000 20%
Any rejection of +ve NPV projects is against the 1
E 300,000 1.2 60,000 17%
2
goal of shareholder wealth maximization.

9.3 Project Ranking Problems 9.3 Project Ranking Problems

Size disparity
Without capital rationing: all projects with NPV>=0 should Consider the 2 mutually exclusive projects A & B in the
be accepted. table:
With capital rationing: project ranking becomes important
(because not all acceptable projects can be undertaken). Project A Project B
Initial Outlay 500,000 2,000,000
Discounted cash flow criteria (NPV, IRR, PI, etc.) will all NPV 120,000 150,000
give the same accept / reject decision BUT they wont PI 1.24 1.075
always rank projects in the same order. IRR 23% 18%

3 issues:
1. Size disparity If your capital budget is limited to 2million, what other
investments could you undertake together with Project A?
2. Time disparity
3. Unequal lives (If there is no capital rationing, then you would select Project B since it
has the higher NPV and, if there was another worthwhile investment,
3 you would undertake that also). 4

9.3 Project Ranking Problems 9.3 Project Ranking Problems

Time disparity Unequal lives
Consider the 2 mutually exclusive projects B & C in the table: Consider a firm with a 10% MARR that requires replacement machinery
and must decide whether to invest in a machine with a useful life of 3
Project B Project C years or an alternative machine with a 5-year life span. The cash flows
Initial Outlay 2,000,000 2,000,000 for both are shown in the table:
NPV 150,000 180,000 Machine 1 Machine 2
PI 1.075 1.09 Initial Outlay 1,000,000 1,500,000
IRR 18% 12% Year 1 inflow 500,000 480,000
Year 2 inflow 500,000 480,000
The difference in IRR results from the different reinvestment rate
assumptions: Year 3 inflow 500,000 480,000
For NPV and PI, assumed reinvestment rate = MARR (most Year 4 inflow 480,000
conservative)
Year 5 inflow 480,000
For IRR, assumed reinvestment rate = IRR (optimistic?)
(Calculating the MIRR allows you to input your own choice of NPV 243,426 319,578
reinvestment rate.) PI 1.24 1,21
5 IRR 23% 18% 6
Does it matter if there is capital rationing or not in this case?

Emlyn Witt 1
EPJ3760 Construction Investments Lecture 9: November 2013

9.3 Project Ranking Problems 9.4 Equivalent Annual Annuity

Unequal lives (continued)
The NPV for Machine 2 is greater BUT, since Machine 1 will need
replacement in year 4, the 2 single investments are not directly
comparable.
In this situation, we can create and compare 2 replacement chains
(i.e. we assume that Machine 1 will be replaced by another Machine 1
and that Machine 2 will be replaced by another Machine 2 indefinitely
into the future).
To compare replacement chains, we can either compare:
5 x Machine 1 cash flows with 3 x Machine 2 (i.e. a 15-year
replacement chain)
OR
calculate and compare the Equivalent Annual Annuity (EAA) for
each project
7 So, a replacement chain based on Machine 1 is the better investment.
Equivalent Annual Annuity (EAA) = an annuity cash flow (the same
amount at the end of each year) which yields the same NPV
EAA =
( )
If (as in the Table on Slide 6)
for Machine 1: MARR = 10%; NPV = 243,426; life span = 3 years
for Machine 2: MARR = 10%; NPV = 319,578; life span = 5 years
then:
For Machine 1: EAA = 243426/2.4869 = 97895
For Machine 2: EAA = 319578/3.7908 = 84304
8

Emlyn Witt 2