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. • ame managers are highly growth minded whereas others are not. • The outloo! for future investment opportunities that may not be feasible if e"tensive current commitments are underta!e.• The funds provided by the current operations less dividends. • The feasibility of ac#uiring additional capital through borrowing or sale of additional stoc!. $ead%time and costs of financial mar!et transactions can influence spending. • &eriod of impending change in management personnel, when the status #uo is maintained.• Management attitudes toward not. 'apital 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 e"cluded because financial capital is limited. This is !nown 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. ( company may adopt a posture of capital rationing because it is fearful of too much growth or hesitant to use e"ternal sources of financing.
Capital RationingMany 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 runprofitability 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. • ame managers are highly growth minded whereas others are not.
• The outloo! for future investment opportunities that may not be feasible if e"tensivecurrent commitments are underta!e.
• The funds provided by the current operations less dividends. • The feasibility of ac#uiring additional capital through borrowing or sale of additional
stoc!. $ead%time and costs of financial mar!et transactions can influence spending. • &eriod of impending change in management personnel, when the status #uo is
maintained. • Management attitudes toward not.
'apital Rationing occurs when a company has more amounts of capital budgeting projectswith positive net present values than it has money to invest in them. Therefore, some
projects that should be accepted are e"cluded because financial capital is limited.
This is !nown as artificial constraint because the management may dictate the amount to beinvested 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 projectswith net present values are accepted.
( company may adopt a posture of capital rationing because it is fearful of too much growth
• Hard Capital Rationing: This arises when constraints are e"ternally determined.
This will not occur under perfect mar!et • Soft Capital Rationing: This arises with internal, management%imposed limits on
investment e"penditure.
Reasons for Capital Rationing
There are basically two types of reasons of capital rationing.
• External ReasonsThese arise when a firm is unable to borrow from the outside. )or e"ample if the firm
is under financial distress, tight credit conditions, firm has a new unproven product.*orrowing limits are imposed by ban!s particularly in relation to smaller firms and
individuals. • Internal Reasons
o &rivate owned company+ wners might decide that e"pansion is a trouble not
worth ta!ing. )or e"ample there may that management fear to lose theircontrol in the company.
o -ivisional 'onstraints+ pper management allocates a fi"ed amount for each
division as part of the overall corporate strategy. This arise from a point ofview of a department, cost centre or wholly owned subsidiary, the budgetaryconstraints determined by senior management or head office.
o /uman Resource $imitations+ 'ompany does not have enough middle
management to manage the new e"pansions o -ilution+ )or e"ample, there may be a reluctance to issue further e#uity by
management fearful of losing control of the company.
o -ebt 'onstraints+ 0arlier debt issues might prohibit the increase in the firms
debt beyond a certain level, as stipulated in previous debt contracts. )or
e"ample bondholders re#uiring in the bond contract, that they would accept ama"imum -ebt%to%(sset ratio 1 234.
'apital Rationing could be said to signal a managerial failure to convince suppliers of funds
of the value of the available projects. (lthough there may be something in this argument, inpractice it is not a well%informed judgement. )urthermore, even if there were no limits onthe total amounts of available finance, in reality the price may vary with the si5e as well as
)he term dividend re*ers to that part o* a*ter+ta, pro*it which is distributed tothe owners -shareholders. o* the company/ )he undistributed part o* the pro*it is !nown asRetained earnings/ Higher the dividend payout% lower will be retained earnings/
)he dividend policy o* a company re*ers to the views and policies o* the management with
respect o* distribution o* dividends/ )he dividend policy o* a company should aim atshareholder+wealth ma,imi0ation/
)he essence o* dividend policy is1I* the company is con*ident o* generating more than mar!et returns then only it should retainhigher pro*its and pay less as dividends -or pay no dividends at all.% as the shareholders cane,pect higher share prices based on higher RoI o* the company/ However% i* the company is notcon*ident o* generating more than mar!et returns% it should pay out more dividends -or #''2dividends./ )his is done *or two reasons/ 3ne% the shareholders pre*er early receipt o* cash-li4uidity pre*erence theory. and second% the shareholders can invest this cash to generate morereturns -since mar!et returns are e,pected to be higher than returns generated by the company./
3ver the years% various models have been developed that establish the relationship betweendividends and stoc! prices/ )he most important o* them is 5alter Model1
Walter Model
"ro* 6ames E/ 5alter devised an easy and simple *ormula to show how dividend can be used toma,imi0e the wealth position o* shareholders/ He considers dividend as one o* the important*actors determining the mar!et valuation/ According to 5alter% in the long run% share pricesre*lect the present value o* *uture stream o* dividends/ Retained earnings in*luence stoc! pricesonly through their e**ect on *urther dividends/Assumptions:
)he company is a going concern with perpetual li*e span/)he only source o* *inance is retained earnings/ i/e/ no other alternative means o* *inancing/)he cost o* capital and return on investment are constant throughout the li*e o* the company/According to 5alter Model%P = D ! "# $ D% & R'I ( )c* ( )c
"7 Mar!et price per share E7 Earnings per share8 7 8ividend per share 9c7 Cost o* Capital -Capitalisation rate.R3I 7 Return on Investment -also called return on internal retention.
)he model considers internal rate o* return -IRR.% mar!et Capitalisation rate -9c. and dividend
payout ratio in determination o* share prices/ However% it ignores various other *actorsdetermining the share prices/ It *ails to appropriately calculate prices o* companies that resort toe,ternal sources o* *inance/ Further% the assumption o* constant cost o* capital and constantreturn are unrealistic/I* the internal rate o* return *rom retained earnings -RoI. is higher than the mar!et capitali0ationrate% the value o* ordinary shares would be high even i* the dividends are low/ However% i* theRoI within the business is lower than what mar!et e,pects% the value o* shares would be low/ Insuch cases% the shareholders would e,pect a higher dividend/I+ RoI , )c- Price would .e hi/h even i+ Dividends are low
5alter model e,plains why mar!et prices o* shares o* growth companies are high even i*
dividend payout is low/ It also e,plains why the mar!et prices o* shares o* certain companieswhich pay higher dividend and retain low pro*its are high/#&le:
A :td/ paid a dividend o* Rs ; per share *or &''(+#'/ the company *ollows a *i,ed dividend payout ratio o* $'2 and earns a return o* #<2 on its investments/ Cost o* capital is #&2/ )hee,pected price o* the shares o* A :td/ using 5alter Model would be calculated as *ollows
E"S 7 8ividend = payout Ratio 7 ; = '/$' 7 Rs/#>/>?According to 5alter Model%
" 7 @8 -E + 8. , R3I = 9cB = 9c
" 7 @; #>/>? + ;/''. , '/#< = '/#&B = '/#&
" 7 #<?/;'
Motives *or holding cash111
Nearly every investor holds a certain amount of cash. That's because cash can play a vital role inmeeting a short-term savings goal or play a larger part in a long-term asset portfolio. So whether it's tomeet 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 forholding cash in a portfolio. Next we'll tal briefly about the performance of cash investments over
Pa2.ac3 period in business and economics re*ers to the period o* time re4uired *or the return onan investment to repay the sum o* the original investment/ For e,ample% a G#''' investmentwhich returned G;'' per year would have a two year paybac! period/ It intuitively measures howlong something ta!es to pay *or itsel*/ Shorter paybac! periods are obviously pre*erable tolonger paybac! periods -all else being e4ual./ "aybac! period is widely used due to its ease o*
use despite recogni0ed limitations% described below/
)he e,pression is also widely used in other types o* investment areas% o*ten with respect toenergy e**iciency technologies% maintenance% upgrades% or other changes/ For e,ample% acompact *luorescent light bulb may be described o* having a paybac! period o* a certain numbero* years or operating hours% assuming certain costs/ Here% the return to the investment consists o*reduced operating costs/ Although primarily a *inancial term% the concept o* a paybac! period isoccasionally e,tended to other uses% such as energy paybac! period -the period o* time overwhich the energy savings o* a proect e4ual the amount o* energy e,pended since proectinception. these other terms may not be standardi0ed or widely used/
"aybac! period as a tool o* analysis is o*ten used because it is easy to apply and easy tounderstand *or most individuals% regardless o* academic training or *ield o* endeavour/ 5henused care*ully or to compare similar investments% it can be 4uite use*ul/ As a stand+alone tool tocompare an investment with doing nothing% paybac! period has no e,plicit criteria *ordecision+ma!ing -e,cept% perhaps% that the paybac! period should be less than in*inity./
)he paybac! period is considered a method o* analysis with serious limitations and 4uali*ications*or its use% because it does not properly account *or the time value o* money% ris! % *inancing orother important considerations such as the opportunity cost/ 5hilst the time value o* money can be recti*ied by applying a weight average cost o* capital discount% it is generally agreed that thistool *or investment decisions should not be used in isolation/ Alternative measures o* return
pre*erred by economists are net present value and internal rate o* return/ An implicit assumptionin the use o* paybac! period is that returns to the investment continue a*ter the paybac! period/"aybac! period does not speci*y any re4uired comparison to other investments or even to notma!ing 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 (D!"#") or simply the rate of return ("#").$%& In
the conte't of savings and loans the I"" 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).
)he internal rate o* return on an investment or potential investment is the annualized effectivecompounded return rate that can be earned on the invested capital/
In more *amiliar terms% the IRR o* an investment is the interest rate at which the costs o* theinvestment lead to the bene*its o* the investment/ )his means that all gains *rom the investmentare inherent to the time value o* money and that the investment has a 0ero net present value atthis interest rate/
4ses
ecause the internal rate o* return is a rate 4uantity% it is an indicator o* the e**iciency% 4uality% oryield o* an investment/ )his is in contrast with the net present value% which is an indicator o* thevalue or magnitude o* an investment/
An investment is considered acceptable i* its internal rate o* return is greater than an establishedminimum acceptable rate o* return/ In a scenario where an investment is considered by a *irmthat has e4uity holders% this minimum rate is the cost o* capital o* the investment -which may bedetermined by the ris!+adusted cost o* capital o* alternative investments./ )his ensures that theinvestment is supported by e4uity holders since% in general% an investment whose IRR e,ceeds its
cost o* capital adds value *or the company -i/e/% it is pro*itable./
1alculation
iven a collection o* pairs -time% cash *low. involved in a proect% the internal rate o* return*ollows *rom the net present value as a *unction o* the rate o* return/ A rate o* return *or whichthis *unction is 0ero is an internal rate o* return/
iven the -period% cash *low. pairs -n% C n. where n is a positive integer% the total number o*
periods N % and the net present value N"J% the internal rate o* return is given by r in1
Note that the period is usually given in years% but the calculation may be made simpler i* r iscalculated using the period in which the maority o* the problem is de*ined -e/g/% using months i*most o* the cash *lows occur at monthly intervals. and converted to a yearly period therea*ter/
Note that any *i,ed time can be used in place o* the present -e/g/% the end o* one interval o* anannuity. the value obtained is 0ero i* and only i* the N"J is 0ero/
In the case that the cash *lows are random variables% such as in the case o* a li*e annuity% thee,pected values are put into the above *ormula/
3*ten% the value o* r cannot be *ound analytically/ In this case% numerical methods or graphical
In cases where one proect has a higher initial investment than a second mutually e,clusive proect% the *irst proect may have a lower IRR -e,pected return.% but a higher N"J -increase inshareholders wealth. and should thus be accepted over the second proect -assuming no capitalconstraints./
IRR assumes reinvestment o* interim cash *lows in proects with e4ual rates o* return -thereinvestment can be the same proect or a di**erent proect./ )here*ore% IRR overstates the annuale4uivalent rate o* return *or a proect whose interim cash *lows are reinvested at a rate lower thanthe calculated IRR/ )his presents a problem% especially *or high IRR proects% since there is*re4uently not another proect available in the interim that can earn the same rate o* return as the*irst proect/
5hen the calculated IRR is higher than the true reinvestment rate *or interim cash *lows% the measure willoverestimate sometimes very signi*icantly the annual e4uivalent return *rom the proect/ )he*ormula assumes that the company has additional proects% with e4ually attractive prospects% in which toinvest the interim cash *lows/ @&B
)his ma!es IRR a suitable -and popular. choice *or analy0ing venture capital and other privatee4uity investments% as these strategies usually re4uire several cash investments throughout the proect% but only see one cash out*low at the end o* the proect -e/g/% via I"3 or MDA./
Since IRR does not consider cost o* capital% it should not be used to compare proects o* di**erentduration/ Modi*ied Internal Rate o* Return -MIRR. does consider cost o* capital and provides a better indication o* a proects e**iciency in contributing to the *irms discounted cash *low/
In the case o* positive cash *lows *ollowed by negative ones - + + +. the IRR may havemultiple values/ In this case a discount rate may be used *or the borrowing cash *low and the IRRcalculated *or the investment cash *low/ )his applies *or e,ample when a customer ma!es a
deposit be*ore a speci*ic machine is built/
In a series o* cash *lows li!e -+#'% &#% +##.% one initially invests money% so a high rate o* return is best% but then receives more than one possesses% so then one owes money% so now a low rate o*return is best/ In this case it is not even clear whether a high or a low IRR is better/ )here mayeven be multiple IRRs *or a single proect% li!e in the e,ample '2 as well as #'2/ E,amples o*this type o* proect are strip mines and nuclear power plants% where there is usually a large cashout*low at the end o* the proect/
In general% the IRR can be calculated by solving a polynomial e4uation/ Sturms theorem can beused to determine i* that e4uation has a uni4ue real solution/ In general the IRR e4uation cannot
be solved analytically but only iteratively/
5hen a proect has multiple IRRs it may be more convenient to compute the IRR o* the proectwith the bene*its reinvestmented/@&B Accordingly% MIRR is used% which has an assumedreinvestment rate% usually e4ual to the proects cost o* capital/
8espite a strong academic pre*erence *or N"J% surveys indicate that e,ecutives pre*er IRR over N"J @$B/ Apparently% managers *ind it easier to compare investments o* di**erent si0es in terms o*
percentage rates o* return than by dollars o* N"J/ However% N"J remains the more accuratere*lection o* value to the business/ IRR% as a measure o* investment e**iciency may give betterinsights in capital constrained situations/ However% when comparing mutually e,clusive proects% N"J is the appropriate measure/
edit* Mathematics
Mathematically the value o* the investment is assumed to undergo e,ponential growth or decayaccording to some rate o* return -any value greater than +#''2.% with discontinuities *or cash*lows% and the IRR o* a series o* cash *lows is de*ined as any rate o* return that results in a net present value o* 0ero -or e4uivalently% a rate o* return that results in the correct value o* 0eroa*ter the last cash *low./
)hus internal rate-s. o* return *ollow *rom the net present value as a *unction o* the rate o*return/ )his *unction is continuous/ )owards a rate o* return o* +#''2 the net present valueapproaches in*inity with the sign o* the last cash *low% and towards a rate o* return o* positive
in*inity the net present value approaches the *irst cash *low -the one at the present./ )here*ore% i*the *irst and last cash *low have a di**erent sign there e,ists an internal rate o* return/ E,ampleso* time series without an IRR1
• #nly negative cash flows * the 1P2 is negative for every rate of return.• (*% % *%) rather small positive cash flow between two negative cash flows9
the 1P2 is a 3uadratic function of %(%;r ) where r is the rate of return or putdifferently a 3uadratic function of the discount rate r (%;r )9 the highest 1P2is *./0 for r 7 %<.
In the case o* a series o* e,clusively negative cash *lows *ollowed by a series o* e,clusively
positive ones% consider the total value o* the cash *lows converted to a time between the negativeand the positive ones/ )he resulting *unction o* the rate o* return is continuous andmonotonically decreasing *rom positive in*inity to negative in*inity% so there is a uni4ue rate o*return *or which it is 0ero/ Hence the IRR is also uni4ue -and e4ual./ Although the N"J+*unctionitsel* is not necessarily monotonically decreasing on its whole domain% it is at the IRR/
Similarly% in the case o* a series o* e,clusively positive cash *lows *ollowed by a series o*e,clusively negative ones the IRR is also uni4ue/
• ='tended Internal "ate of "eturn: The Internal rate of return calculates therate at which the investment made will generate cash flows. This method isconvenient if the pro4ect has a short duration but for pro4ects which has anoutlay of many years this method is not practical as I"" ignores the Time2alue of >oney. To take into consideration the Time 2alue of >oney='tended Internal "ate of "eturn was introduced where all the future cashflows are first discounted at a discount rate and then the I"" is calculated.
This method of calculation of I"" is called ='tended Internal "ate of "eturn or?I"".
Does inclusion of debt create value for the company?
@hen a firm grows it needs capital and that capital can come from debt or e3uity.
Debt has two important advantages. !irst interest paid on Debt is ta' deductible to
the corporation. This effectively reduces the debt5s effective cost. Aecond debtholders get a fi'ed return so stockholders do not have to share their profits if the
business is e'tremely successful. Debt has disadvantages as well the higher the
debt ratio the riskier the company hence higher the cost of debt as well as e3uity.
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 3uarters away.
apital structure policy is a trade*off between risk and return:
B Csing debt raises the risk borne by stock holdersB Csing more debt generally leads to a higher e'pected rate on e3uity.
