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 &

Capital Rationing

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What is Capital Investment?· Long Term commitment of scares resources

Why is Capital Investment Decision Important?· Generation of future income

How to evaluate Capital Investments?

· Time value methods

Effects of Capital Rationing· T es of Decisions and Constraints

Effects of Taxation and Inflation·

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1) Compounding & Discounting Formula=

 

i = Interest Ratet = Time PeriodF = Final Sum

ompoun ng scount ngF = P(1+i)^t P = F / (1+i)^t

2 Assum tions initial setProject independenceSimple investmentDiscount rate is known

 Complies with maximizing NPW

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Investment Decision / Appraisal

3) "Common Sense" Decision Rules

Investment Initial Net Cash Proceeds

Proposal Outlay Year 1 Year 2A 10,000 10,000

  , , ,

C 10,000 3,762 7,762D 10,000 5,762 5,762

· Assume A&B and C&D are mutually exclusive

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Investment Decision / Appraisal

3) "Common Sense" Decision Rules

Investment Initial Net Cash Proceeds

Proposal Outlay Year 1 Year 2A 10,000 10,000

  , , ,

C 10,000 3,762 7,762D 10,000 5,762 5,762

· Assume A&B and C&D are mutually exclusive

 

then larger amount in return better.Select B

Rule 2 C&D if same outlay, and return,en ear er re urn s e er.

Select D

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Ca ital Rationin arise because of limited resourcesDecision NOW affects FUTURE, but FUTURE depends on decision NOW

Types of Capital Rationing problemso = x erna cons ra n s

(2) Hard = Internal Constraints(a) Control issuesb Political issues

Single Period ConstraintsMany project single year

Accept project based on :(a) Benefit Cost Ration (NPV/Outlay)

(b) Profitability Index (PV of  Benefit/PV of  Outlay)

(c) LP method

Multiple Period ConstraintsMany projects over many years

No clear cut answer BUT :(a) Dynamic Programming

(b) Other

 simulation

 models

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Reasons why Capital Rationing occurs

 prices are depressed

Restrictions on bank lending due to government controls

The costs associated with making a small equity issue may be too great

 more loans

Limitation of  methods usedAssumption of  divisible projects

No account of risk of ro ect and attitude towards risk b com an and shareholders Interdependencies between projects are difficult to establish

L near re at ons ps are usua y assume ,  a  ract on o  a pro ect  s ta en  o we may not get the same proportion of  benefits and cost

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ITEMS / TIME PERIOD 1 ...... n

 Cash SalesDebtor PaymentsSale of Fixed AssetsNew Share Issue / Capital

Calculating

New Loans

Realized Investments

TOTAL INCOME X

 

EXPENDITURE / PAYMENTSCash PaymentsCreditor PaymentsWages & Salaries

en a esHeating & LightingInterest PaymentsDividendsLoan Repayment

TaxationPurchase of Fixed Assets

TOTAL EXPENDITURE Y

NET CASH FLOW X Y

Open Cash Balance (b/f)Close Cash Balance (c/f)

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Decision Criteria

1) What decision rules can we use? this creates wealth and should be adopted

< c) If two or more actions satisfy Rule a

but are mutually exclusive, adopt action

which generates greatest NPW

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Calculate the variance for each period of each year

Squaring the Variance, and finding the deviations from theexpected returns for each year

 

Find E(NPV) average value for each year and discount by theinterest rate (cost of capital) and deduct outlay

Find SD(NPV) for each year by discounting the variance with

the interest rate (cost of capital) BUT by (1+i)^2t

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Inflation Effects

What is inflation?"An increase in monetary units to obtain the same benefit"

Types of inflationSpecific (Price changes)General Purchasin Power Chan es 

Money Terms = General Inflation Rate · Real Rate of Interest

ec s :(1) Decrease in real after tax returns

DepreciationShorter a back

(2) Inflation BiasC & H Survey 1976

Under investment

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Taxation Effects

Taxationa) Impact on Cash Flow

 c) Impact on Perceived Risk