Capital Rationing

Many companies specify an overall limit on the total budget for capital spending. There is no
conceptual justification for such budget ceiling, because all projects that enhance long run
profitability should be accepted.

The factors for putting limit

• Net present values or IRR may strongly influence the overall budget amount
• Top management’s philosophy toward capital spending.
• Same managers are highly growth minded whereas others are not.
• The outlook for future investment opportunities that may not be feasible if extensive
current commitments are undertake.
• The funds provided by the current operations less dividends.
• The feasibility of acquiring additional capital through borrowing or sale of additional
stock. Lead-time and costs of financial market transactions can influence spending.
• Period of impending change in management personnel, when the status quo is
maintained.
• Management attitudes toward not.

Capital Rationing occurs when a company has more amounts of capital budgeting projects
with positive net present values than it has money to invest in them. Therefore, some
projects that should be accepted are excluded because financial capital is limited.
This is known as artificial constraint because the management may dictate the amount to be
invested for project purposes.

It is also the artificial constraints because the amount is not based on the product marginal
analysis in which the return for each proposal is related to the cost of capital and projects
with net present values are accepted.

A company may adopt a posture of capital rationing because it is fearful of too much growth
or hesitant to use external sources of financing.
Types of Capital Rationing

• Hard Capital Rationing: This arises when constraints are externally determined.
This will not occur under perfect market
• Soft Capital Rationing: This arises with internal, management-imposed limits on
investment expenditure.

Reasons for Capital Rationing

There are basically two types of reasons of capital rationing.

• External Reasons
These arise when a firm is unable to borrow from the outside. For example if the firm
is under financial distress, tight credit conditions, firm has a new unproven product.
Borrowing limits are imposed by banks particularly in relation to smaller firms and
individuals.
• Internal Reasons
o Private owned company: Owners might decide that expansion is a trouble not
worth taking. For example there may that management fear to lose their
control in the company.
o Divisional Constraints: Upper management allocates a fixed amount for each
division as part of the overall corporate strategy. This arise from a point of
view of a department, cost centre or wholly owned subsidiary, the budgetary
constraints determined by senior management or head office.
o Human Resource Limitations: Company does not have enough middle
management to manage the new expansions
o Dilution: For example, there may be a reluctance to issue further equity by
management fearful of losing control of the company.
 o Debt Constraints: Earlier debt issues might prohibit the increase in the firms
debt beyond a certain level, as stipulated in previous debt contracts. For
example bondholders requiring in the bond contract, that they would accept a
maximum Debt-to-Asset ratio = 40%.

Capital Rationing could be said to signal a managerial failure to convince suppliers of funds
of the value of the available projects. Although there may be something in this argument, in
practice it is not a well-informed judgement. Furthermore, even if there were no limits on
the total amounts of available finance, in reality the price may vary with the size as well as
the term of the loan.

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Dividend Decision – Walter Model
Posted by Tushar Mathur on April 13th, 2009

The term dividend refers to that part of after-tax profit which is distributed to
the owners (shareholders) of the company. The undistributed part of the profit is known as
Retained earnings. Higher the dividend payout, lower will be retained earnings.

The dividend policy of a company refers to the views and policies of the management with
respect of distribution of dividends. The dividend policy of a company should aim at
shareholder-wealth maximization.

The essence of dividend policy is:

If the company is confident of generating more than market returns then only it should retain
higher profits and pay less as dividends (or pay no dividends at all), as the shareholders can
expect higher share prices based on higher RoI of the company. However, if the company is not
confident of generating more than market returns, it should pay out more dividends (or 100%
dividends). This is done for two reasons. One, the shareholders prefer early receipt of cash
(liquidity preference theory) and second, the shareholders can invest this cash to generate more
returns (since market returns are expected to be higher than returns generated by the company).

Over the years, various models have been developed that establish the relationship between
dividends and stock prices. The most important of them is Walter Model:

Walter Model
Prof James E. Walter devised an easy and simple formula to show how dividend can be used to
maximize the wealth position of shareholders. He considers dividend as one of the important
factors determining the market valuation. According to Walter, in the long run, share prices
reflect the present value of future stream of dividends. Retained earnings influence stock prices
only through their effect on further dividends.
Assumptions:
The company is a going concern with perpetual life span.
The only source of finance is retained earnings. i.e. no other alternative means of financing.
The cost of capital and return on investment are constant throughout the life of the company.
According to Walter Model,
P = [D + (E - D) x ROI / Kc] / Kc
P= Market price per share E= Earnings per share
D = Dividend per share Kc= Cost of Capital (Capitalisation rate)
ROI = Return on Investment (also called return on internal retention)

The model considers internal rate of return (IRR), market Capitalisation rate (Kc) and dividend
payout ratio in determination of share prices. However, it ignores various other factors
determining the share prices. It fails to appropriately calculate prices of companies that resort to
external sources of finance. Further, the assumption of constant cost of capital and constant
return are unrealistic.
If the internal rate of return from retained earnings (RoI) is higher than the market capitalization
rate, the value of ordinary shares would be high even if the dividends are low. However, if the
RoI within the business is lower than what market expects, the value of shares would be low. In
such cases, the shareholders would expect a higher dividend.
If RoI > Kc, Price would be high even if Dividends are low

Walter model explains why market prices of shares of growth companies are high even if
dividend payout is low. It also explains why the market prices of shares of certain companies
which pay higher dividend and retain low profits are high.
Example:
A Ltd. paid a dividend of Rs 5 per share for 2009-10. the company follows a fixed dividend
payout ratio of 30% and earns a return of 18% on its investments. Cost of capital is 12%. The
expected price of the shares of A Ltd. using Walter Model would be calculated as follows

EPS = Dividend / payout Ratio = 5 / 0.30 = Rs.16.67

According to Walter Model,

P = [D + (E - D) x ROI / Kc] / Kc

P = [5 + 16.67 - 5.00) x 0.18 / 0.12] / 0.12

P = 187.50

Motives for holding cash:::

Nearly every investor holds a certain amount of cash. That's because cash can play a vital role in
meeting a short-term savings goal or play a larger part in a long-term asset portfolio. So whether it's to
meet a short-term or longer-term need, there is always a good reason for holding cash.

In this article we're going to discuss some of the more practical as well as the strategic reasons for
holding cash in a portfolio. Next we'll talk briefly about the performance of cash investments over
time. Finally, we'll finish up with an outline of the various cash funds you can own as part of your
investment portfolio.

Reasons for Holding Cash

Perhaps the best explanation for holding cash in a portfolio was summarized by John Maynard
Keynes - after which Keynesian economics or Keynesian Theory is named. Keynesian economic
theory states that both the state (government) and private sectors play an important role in the
health of an economy. In particular, Keynes also spoke about the importance of cash.

Three Motives for Holding Cash

In his publication on The General Theory of Employment, Interest, & Money, Keynes outlined
three reasons, or motives, for holding money or cash:

• Transaction Motive - cash is held to pay for goods or services. It is useful for conducting our
everyday transactions or purchases.
• Precautionary Motive - cash is a relatively safe investment. Cash investments rarely lose
value (as can stocks or bonds) and are therefore held for safety reasons in a balanced portfolio.
• Asset or Speculative Motive - cash investments provide a return to their holders.

There can be many variations on the reasons mentioned above, but these three reasons are
perhaps the best overall explanation as to why cash plays an important role in any investor's
portfolio.

At a very practical level we own cash investments to pay for our daily or monthly expenses. At a
more strategic level, cash provides an investor with a way to control risk as well as gain a return
on their investment.

Pay back Period:

Payback period in business and economics refers to the period of time required for the return on
an investment to "repay" the sum of the original investment. For example, a $1000 investment
which returned $500 per year would have a two year payback period. It intuitively measures how
long something takes to "pay for itself." Shorter payback periods are obviously preferable to
longer payback periods (all else being equal). Payback period is widely used due to its ease of
use despite recognized limitations, described below.

The expression is also widely used in other types of investment areas, often with respect to
energy efficiency technologies, maintenance, upgrades, or other changes. For example, a
compact fluorescent light bulb may be described of having a payback period of a certain number
of years or operating hours, assuming certain costs. Here, the return to the investment consists of
reduced operating costs. Although primarily a financial term, the concept of a payback period is
occasionally extended to other uses, such as energy payback period (the period of time over
which the energy savings of a project equal the amount of energy expended since project
inception); these other terms may not be standardized or widely used.

Payback period as a tool of analysis is often used because it is easy to apply and easy to
understand for most individuals, regardless of academic training or field of endeavour. When
used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to
compare an investment with "doing nothing," payback period has no explicit criteria for
decision-making (except, perhaps, that the payback period should be less than infinity).

The payback period is considered a method of analysis with serious limitations and qualifications
for its use, because it does not properly account for the time value of money, risk, financing or
other important considerations such as the opportunity cost. Whilst the time value of money can
be rectified by applying a weight average cost of capital discount, it is generally agreed that this
tool for investment decisions should not be used in isolation. Alternative measures of "return"
preferred by economists are net present value and internal rate of return. An implicit assumption
in the use of payback period is that returns to the investment continue after the payback period.
Payback period does not specify any required comparison to other investments or even to not
making an investment.

IRR:

The internal rate of return (IRR) is a rate of return used in capital budgeting to
measure and compare the profitability of investments. It is also called the
discounted cash flow rate of return (DCFROR) or simply the rate of return (ROR).[1] In
the context of savings and loans the IRR is also called the effective interest rate.
The term internal refers to the fact that its calculation does not incorporate
environmental factors (e.g., the interest rate or inflation).

The internal rate of return on an investment or potential investment is the annualized effective
compounded return rate that can be earned on the invested capital.
In more familiar terms, the IRR of an investment is the interest rate at which the costs of the
investment lead to the benefits of the investment. This means that all gains from the investment
are inherent to the time value of money and that the investment has a zero net present value at
this interest rate.

Uses
Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or
yield of an investment. This is in contrast with the net present value, which is an indicator of the
value or magnitude of an investment.

An investment is considered acceptable if its internal rate of return is greater than an established
minimum acceptable rate of return. In a scenario where an investment is considered by a firm
that has equity holders, this minimum rate is the cost of capital of the investment (which may be
determined by the risk-adjusted cost of capital of alternative investments). This ensures that the
investment is supported by equity holders since, in general, an investment whose IRR exceeds its
cost of capital adds value for the company (i.e., it is profitable).

Calculation
Given a collection of pairs (time, cash flow) involved in a project, the internal rate of return
follows from the net present value as a function of the rate of return. A rate of return for which
this function is zero is an internal rate of return.

Given the (period, cash flow) pairs (n, Cn) where n is a positive integer, the total number of
periods N, and the net present value NPV, the internal rate of return is given by r in:

Note that the period is usually given in years, but the calculation may be made simpler if r is
calculated using the period in which the majority of the problem is defined (e.g., using months if
most of the cash flows occur at monthly intervals) and converted to a yearly period thereafter.

Note that any fixed time can be used in place of the present (e.g., the end of one interval of an
annuity); the value obtained is zero if and only if the NPV is zero.

In the case that the cash flows are random variables, such as in the case of a life annuity, the
expected values are put into the above formula.

Often, the value of r cannot be found analytically. In this case, numerical methods or graphical
methods must be used.
Example

If an investment may be given by the sequence of cash flows

Year Cash Flow

( n) (Cn)

0 -4000
then the IRR r is given by

1 1200

2 1410

3 1875

4 1050

In this case, the answer is 14.3%.

[edit] Numerical solution

Since the above is a manifestation of the general problem of finding the roots of the equation
NPV(r), there are many numerical methods that can be used to estimate r. For example, using
the secant method, r is given by

where rn is considered the nth approximation of the IRR.

This formula initially requires two unique pairs of estimations of the IRR and NPV (r0,NPV0)
and (r1,NPV1), and produces a sequence of

that may converge to as . If the sequence converges, then iterations of the formula can
continue indefinitely so that r can be found to an arbitrary degree of accuracy.
The convergence behaviour of the sequence is governed by the following:

• If the function NPV(i) has a single real root r, then the sequence will
converge reproducibly towards r.
• If the function NPV(i) has n real roots , then the sequence will
converge to one of the roots and changing the values of the initial pairs may
change the root to which it converges.
• If function NPV(i) has no real roots, then the sequence will tend towards
infinity.

Having when NPV or when NPV0 < 0 may speed up convergence of rn to r.

[edit] Problems with using internal rate of return

As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive
projects, but only to decide whether a single project is worth investing in.

NPV vs discount rate comparison for two mutually exclusive projects. Project 'A' has
a higher NPV (for certain discount rates), even though its IRR (=x-axis intercept) is
lower than for project 'B' (click to enlarge)
In cases where one project has a higher initial investment than a second mutually exclusive
project, the first project may have a lower IRR (expected return), but a higher NPV (increase in
shareholders' wealth) and should thus be accepted over the second project (assuming no capital
constraints).

IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the
reinvestment can be the same project or a different project). Therefore, IRR overstates the annual
equivalent rate of return for a project whose interim cash flows are reinvested at a rate lower than
the calculated IRR. This presents a problem, especially for high IRR projects, since there is
frequently not another project available in the interim that can earn the same rate of return as the
first project.

When the calculated IRR is higher than the true reinvestment rate for interim cash flows, the measure will
overestimate — sometimes very significantly — the annual equivalent return from the project. The
formula assumes that the company has additional projects, with equally attractive prospects, in which to
invest the interim cash flows. [2]

This makes IRR a suitable (and popular) choice for analyzing venture capital and other private
equity investments, as these strategies usually require several cash investments throughout the
project, but only see one cash outflow at the end of the project (e.g., via IPO or M&A).

Since IRR does not consider cost of capital, it should not be used to compare projects of different
duration. Modified Internal Rate of Return (MIRR) does consider cost of capital and provides a
better indication of a project's efficiency in contributing to the firm's discounted cash flow.

In the case of positive cash flows followed by negative ones (+ + - - -) the IRR may have
multiple values. In this case a discount rate may be used for the borrowing cash flow and the IRR
calculated for the investment cash flow. This applies for example when a customer makes a
deposit before a specific machine is built.

In a series of cash flows like (-10, 21, -11), one initially invests money, so a high rate of return is
best, but then receives more than one possesses, so then one owes money, so now a low rate of
return is best. In this case it is not even clear whether a high or a low IRR is better. There may
even be multiple IRRs for a single project, like in the example 0% as well as 10%. Examples of
this type of project are strip mines and nuclear power plants, where there is usually a large cash
outflow at the end of the project.

In general, the IRR can be calculated by solving a polynomial equation. Sturm's theorem can be
used to determine if that equation has a unique real solution. In general the IRR equation cannot
be solved analytically but only iteratively.

When a project has multiple IRRs it may be more convenient to compute the IRR of the project
with the benefits reinvestmented.[2] Accordingly, MIRR is used, which has an assumed
reinvestment rate, usually equal to the project's cost of capital.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over
NPV [3]. Apparently, managers find it easier to compare investments of different sizes in terms of
percentage rates of return than by dollars of NPV. However, NPV remains the "more accurate"
reflection of value to the business. IRR, as a measure of investment efficiency may give better
insights in capital constrained situations. However, when comparing mutually exclusive projects,
NPV is the appropriate measure.

[edit] Mathematics
Mathematically the value of the investment is assumed to undergo exponential growth or decay
according to some rate of return (any value greater than -100%), with discontinuities for cash
flows, and the IRR of a series of cash flows is defined as any rate of return that results in a net
present value of zero (or equivalently, a rate of return that results in the correct value of zero
after the last cash flow).

Thus internal rate(s) of return follow from the net present value as a function of the rate of
return. This function is continuous. Towards a rate of return of -100% the net present value
approaches infinity with the sign of the last cash flow, and towards a rate of return of positive
infinity the net present value approaches the first cash flow (the one at the present). Therefore, if
the first and last cash flow have a different sign there exists an internal rate of return. Examples
of time series without an IRR:

• Only negative cash flows - the NPV is negative for every rate of return.
• (-1, 1, -1), rather small positive cash flow between two negative cash flows;
the NPV is a quadratic function of 1/(1+r), where r is the rate of return, or put
differently, a quadratic function of the discount rate r/(1+r); the highest NPV
is -0.75, for r = 100%.

In the case of a series of exclusively negative cash flows followed by a series of exclusively
positive ones, consider the total value of the cash flows converted to a time between the negative
and the positive ones. The resulting function of the rate of return is continuous and
monotonically decreasing from positive infinity to negative infinity, so there is a unique rate of
return for which it is zero. Hence the IRR is also unique (and equal). Although the NPV-function
itself is not necessarily monotonically decreasing on its whole domain, it is at the IRR.

Similarly, in the case of a series of exclusively positive cash flows followed by a series of
exclusively negative ones the IRR is also unique.

• Extended Internal Rate of Return: The Internal rate of return calculates the
rate at which the investment made will generate cash flows. This method is
convenient if the project has a short duration, but for projects which has an
outlay of many years this method is not practical as IRR ignores the Time
Value of Money. To take into consideration the Time Value of Money
Extended Internal Rate of Return was introduced where all the future cash
flows are first discounted at a discount rate and then the IRR is calculated.
This method of calculation of IRR is called Extended Internal Rate of Return or
XIRR.

Does inclusion of debt create value for the company?

Introduction To Debt Policy
When a firm grows, it needs capital, and that capital can come from debt or equity.
Debt has two important advantages. First, interest paid on Debt is tax deductible to
the corporation. This effectively reduces the debt's effective cost. Second, debt
holders get a fixed return so stockholders do not have to share their profits if the
business is extremely successful. Debt has disadvantages as well, the higher the
debt ratio, the riskier the company, hence higher the cost of debt as well as equity.
If the company suffers financial hardships and the operating income is not sufficient
to cover interest charges, its stockholders will have to make up for the shortfall and
if they cannot, bankruptcy will result. Debt can be an obstacle that blocks a
company from seeing better times even if they are a couple of quarters away.

Capital structure policy is a trade-off between risk and return:

· Using debt raises the risk borne by stock holders
· Using more debt generally leads to a higher expected rate on equity.