CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing

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Financial Management MGT201

Lesson 12

CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED

CAPITAL.

Learning Objective:

After going through this lecture, you would be able to have an understanding of the following topic

· Capital Rationing

· IRR and NPV interpretation with limited capital

In this lecture, we would discuss the practical side of capital budgeting addressing the problem of

allocating your money among the different possible projects, where the amount of money to invest is

limited.

Companies ration their capital and investments among different opportunities. Similarly, countries

use rationing. For example, some countries ration food. Capital Rationing provide practical basis to the

capital budgeting because the decision of capital budgeting are made within limited financial resources

of the company in real life situations.

Here, the investment in real assets would be discussed. It is mentioned earlier that real assets have

cash flows associated with them. Theses cash flows would be discounted to the present and calculate the

NPV of the project. If, the NPV >0, it will benefit the organization. If the company invest in the project

with positive NPV it will bring value to the company and result in maximization of shareholders' wealth.

As we studied in previous lectures how we could estimate the after tax cash flows. The

Importance of good Cash Flow forecasts and accurate Proforma Cash Flow Statement

Net After-tax Cash Flows = Net Operating Income + Depreciation + Tax Savings from Depreciation +

Net Working Capital + Other Cash Flows

Other Cash Flows: Include Opportunity Costs and Externalities but Exclude Sunken Costs

In capital rationing the most important criterion, which we are using to decide whether to invest

in a projector not is the NPV. The second important criterion, which would be used, is the IRR. There is

a new criterion which we look at in capital rationing is percent budget utilization. In other words, what

percentage of the total money available to invest are you mobilizing? It is important to mobilize as

much money as possible in the projects on which IRR is greater then risk free rate if return because you

want to maximize the return on your portfolio.

We have study about certain special situations, which cause complexities in calculating IRR

using NPV equation. Multiple IRR arises when there is more then one sign changes in cash flow

diagram. In such situations, avoid using NPV equation to calculate the IRR because it would not provide

the correct result. To get the correct answer we should use Modified IRR. In this, you separate the

Incoming and Outgoing Cash Flows at each period in time. Discount all the outflows to the present and

compound all the Inflows to the termination date. Assume reinvestment at a Cost of Capital or Discount

Factor (or Required Return) such as the risk free interest rate.

MIRR is that discount rate which equates the future value of cash inflows to the present value of

cash out flows. We use Common Life or EAA Approach to adjust NPV of projects with different lives.

Now, we discuss the capital rationing and see that how the context of problem changes with

budget constraint.

Until now, we are discussing about the ideal case with no budget constraint. Practically, money

is in short supply & it is only that much money that a company has to spend in different projects.

Therefore, we need to change our analysis in order to take into account the limited resources like money

in making the investment decisions.

Now, first thing to know who is responsible for the decisions relating to capital budgeting and capital

rationing. Generally, the investment decision making is divided in accordance with the size of the

investment and criticality of the investments.

Mandatory (Critical & Necessary for Business and Legal): CEO

Discretionary (R&D, Growth Projects) Investments: Junior Mgmt or division heads

Reasons for Capital Rationing:

What are the reasons because of which you do not invest in a project which provide you highest

return? There are situations in which after calculating the IRR's and NPV's of different projects you are

forced not to invest in the best project. Some reasons are

1. The best project may have a very high initial investment and you may not have that money. So, you

are forced to reject that project as an option.

Financial Management MGT201

2. The company does not have the human resource, knowledge, or talent, which is required to undertake

the project. The project might have high NPV but if you cannot manage it, you are forced not to invest

in that project.

3. The companies have the prevailing fear of debt. In case of Muslim countries, there is a major issue of

"Riba" (interest) among Muslim investors and the companies due to this religious constraint choose not

to borrow money. That is the reason that in many Muslim countries capital rationing has an ethical

bases attach to it. Usually, the investors in these countries invest in the equity based investments as it

has a risk of profit or loss in that kind of investment. We will discuss this topic in the upcoming lectures.

Now, it is important from you to remember that companies have different constraints, which

keep them from investing in the best projects. The fear of debt is justified because when we discuss

about the risk in upcoming lectures you find out that when a company takes on debt its future cash flows

become more risky. Therefore, there is a possibility of default due to which there is a fear of debt. These

are various reasons due to which company decides not to invest in the project with the highest NPV and

some of them involve capital rationing decisions as the following example shows.

Example:

There are 4 Projects (mutually exclusive real asset projects) to choose from. Total budget is

Rs.1, 000

Project

Io=Investment (Rs) IRR

NPV(Rs)

200

40%

300

100

40%

300

35%

200

800

30%

600

Which 3 projects you will choose from the above 4 real asset projects?

We cannot pick all 4 Projects because the Budget Constraint is 1000 and the total investment in

all 3 Projects is 1400 (=200+100+300+800).we have to go through capital rationing process & choose

from among these 4 different projects. We have some options, which are as follows.

Option 1:

If we pick Projects A, B, & C then we have to consider what will be the combined NPV of these

projects and what average IRR will be of this portfolio or combination of projects. Finally, we have to

look an interesting parameter for capital rationing which is what percentage of total budget available is

being utilized if we invest in these projects.

Budget Utilization = 200+100+300 = 600 (out of 1000)

Total NPV of three projects = 300+300+200 = 800

Simple Average IRR = 38% = (40+40+35)/3 Non-weighted

38% seems to be attractive IRR. NPV of 800 looks good relatively to the size of investments. Finally,

we look at percent budget utilization and for this option

Budget Utilization = 200+100+300 = 600

This option is utilizing 60% of total budget.

Now we repeat the same practice for the other options available to us

Option 2: Pick Projects A and D because they have the highest NPV's.

Budget Utilization = 200+800 = 1000

Total NPV = 300+600 = 900

Average IRR = 35%

Option 3: Pick Projects B and D because they have the highest NPV's.

Budget Utilization = 100+800 = 900

Total NPV = 300+600 = 900

Average IRR = 35%

Conclusion

Summary:

Budget Utilization

NPV

Avg IRR

Option 1

Rs.600 (60%)

Rs.800

38%

Option 2

Rs.1000 (100%)

Rs.900

35%

Option 3

Rs.900 (90%)

Rs.900

35%

Financial Management MGT201

It is clear from the summery that option 2 is best option. It carries the highest NPV which is Rs

900 and it also has the highest budget utilization at IRR of roughly 35 %.

Why we not choose option 1:

Option no 1 has the highest IRR of 38% but the problem is that in option 1 our NPV is not the

highest, rather, it is lower than the option 2 and 3.

Secondly, Budget utilization is only 60% and the 40% of the money available for investment is

wasted and is lying idle. What will you do with this money? The idle money available in company

should earn some return on it. If you do not have the attractive project to invest in, you are forced to

keep it in a bank account that will yield 9 to 10 percent. So, the percent of budget utilize by any

portfolio is very important as it should be as close to 100 % as possible.

Thus, we conclude on the basis f maximum NPV and maximum budget utilization criterion that option

2nd is the best.

3 Types of Problems in Capital Rationing:

1. Size Difference of cash flows

2. Timing Difference of cash flows

3. Different (or Unequal) Lives of different projects:

We have discussed the problem of different lives of the projects in previous lectures.

Size Difference (in Investment Outlay):

The differences in initial investment (or outlay) means different extend of budget utilization.

We compare the projects one with small cash flows taking place at regular interval and the other project

has large cash flows taking place at different point in time. If two projects have different cash flows,

where do you invest the un-utilized money or leftover portion of the budget? Money that is not

generating a good return is being wasted and eaten up by Inflation!

Example: Budget Size is Rs 1,500

Two projects are

Project A

Cash Flows: Io= Rs200, Yr 1 = + Rs300

· NPV = Rs 73 (at i=10%)

IRR = 50%

Project B

Cash Flows: Io= Rs1, 500, Yr 1 = + Rs 1,900

· NPV = Rs 227 (at i=10%) IRR = 27%

If we compare two projects the projects A has higher IRR bit we do not make our decision on

IRR because as it is mentioned earlier that the most important criterion would be NPV.

Project B has a highest NPV. Therefore, we choose Project B.IRR is lower because you are receiving

the large cash flow at the later point in time in comparison to the project A.

Timing Difference Problems:

A good project might suffer from a lower IRR even though its NPV is higher. It receives its

larger cash flows later in time.

Example: Budget = Rs 2,500

Project A Cash Flows: Io= -Rs1, 000, Yr1=+Rs100, Yr2=+Rs200, Yr3=+Rs2,000 (late

large cash flow)

NPV = + Rs 758 (at i=10%) IRR = 35%

Project B Cash Flows: Io= -Rs1, 000, Yr1=+650, Yr2=Rs650, Yr3=Rs 650 (Annuity)

NPV = + Rs 616 (at i=10%) IRR = 43%

We would choose Project A on the basis NPV Criteria.

Different Lives Problem:

In comparing two projects or Assets (i.e. Sewing Machines or Printing Machines) with different

lives:

Disadvantage of project with very long life:

Does not give you the opportunity (or option) to replace the equipment quickly in order to keep

pace with technology, better quality, and lower costs

Financial Management MGT201

Disadvantage of project with very short life:

Your money will have to be reinvested in some other project with an uncertain NPV and return so it

is risky. If a good project is not available, the money will earn only a minimal return at the risk free

interest rate.

You should use Common Life and EAA Techniques to quantitatively compare such Projects. You

have studied this topic in detail in the previous lecture.

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