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.

o Human Resource Limitations: Company does not have enough middle management to manage the new expansions o Dilution: For example. cost centre or wholly owned subsidiary. Reasons for Capital Rationing There are basically two types of reasons of capital rationing. management-imposed limits on investment expenditure. the budgetary constraints determined by senior management or head office. For example if the firm is under financial distress. 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. • . there may be a reluctance to issue further equity by management fearful of losing control of the company. Internal Reasons o Private owned company: Owners might decide that expansion is a trouble not worth taking. firm has a new unproven product. tight credit conditions. This arise from a point of view of a department. • External Reasons These arise when a firm is unable to borrow from the outside.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. Borrowing limits are imposed by banks particularly in relation to smaller firms and individuals.

Capital Rationing could be said to signal a managerial failure to convince suppliers of funds of the value of the available projects. as stipulated in previous debt contracts. Although there may be something in this argument. in practice it is not a well-informed judgement. Invest In India Indian Financial News Resource Search þÿ • • • • • • • • • • • • • • • • • • Home About Advertise Subscribe business College Companies Economy healthcare india Insurance Mutual Funds News NRI Banking Paid Reviews Personal Finance Real Estate Stocks . Furthermore. that they would accept a maximum Debt-to-Asset ratio = 40%. For example bondholders requiring in the bond contract. even if there were no limits on the total amounts of available finance.o Debt Constraints: Earlier debt issues might prohibit the increase in the firms debt beyond a certain level. in reality the price may vary with the size as well as the term of the loan.

no other alternative means of financing. The dividend policy of a company should aim at shareholder-wealth maximization. if the company is not confident of generating more than market returns. it should pay out more dividends (or 100% dividends).Dividend Decision – Walter Model Posted by Tushar Mathur on April 13th. According to Walter Model. The only source of finance is retained earnings. P = [D + (E . Walter devised an easy and simple formula to show how dividend can be used to maximize the wealth position of shareholders. lower will be retained earnings. the shareholders prefer early receipt of cash (liquidity preference theory) and second.D) x ROI / Kc] / Kc . 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). The most important of them is Walter Model: Walter Model Prof James E. Assumptions: The company is a going concern with perpetual life span. However. in the long run. One. share prices reflect the present value of future stream of dividends. 2009 The term dividend refers to that part of after-tax profit which is distributed to the owners (shareholders) of the company. According to Walter. He considers dividend as one of the important factors determining the market valuation. the shareholders can invest this cash to generate more returns (since market returns are expected to be higher than returns generated by the company). This is done for two reasons. The undistributed part of the profit is known as Retained earnings. The cost of capital and return on investment are constant throughout the life of the company. Higher the dividend payout. as the shareholders can expect higher share prices based on higher RoI of the company. various models have been developed that establish the relationship between dividends and stock prices. Retained earnings influence stock prices only through their effect on further dividends. The dividend policy of a company refers to the views and policies of the management with respect of distribution of dividends.e. Over the years. i.

50 Motives for holding cash::: Nearly every investor holds a certain amount of cash. the value of ordinary shares would be high even if the dividends are low. market Capitalisation rate (Kc) and dividend payout ratio in determination of share prices. the assumption of constant cost of capital and constant return are unrealistic. P = [D + (E . Cost of capital is 12%. the company follows a fixed dividend payout ratio of 30% and earns a return of 18% on its investments. Further. it ignores various other factors determining the share prices. the value of shares would be low.67 .18 / 0. 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. Example: A Ltd.D) x ROI / Kc] / Kc P = [5 + 16. The expected price of the shares of A Ltd. if the RoI within the business is lower than what market expects. the shareholders would expect a higher dividend.12] / 0. However.16. However. 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. Next we'll talk briefly about the performance of cash investments over .30 = Rs. In such cases.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).12 P = 187. there is always a good reason for holding cash.67 According to Walter Model. So whether it's to meet a short-term or longer-term need.00) x 0. paid a dividend of Rs 5 per share for 2009-10. It fails to appropriately calculate prices of companies that resort to external sources of finance.5. 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. It also explains why the market prices of shares of certain companies which pay higher dividend and retain low profits are high. using Walter Model would be calculated as follows EPS = Dividend / payout Ratio = 5 / 0. If the internal rate of return from retained earnings (RoI) is higher than the market capitalization rate.

At a more strategic is held to pay for goods or services. Three Motives for Holding Cash In his publication on The General Theory of Employment. Cash investments rarely lose value (as can stocks or bonds) and are therefore held for safety reasons in a balanced portfolio. Keynes also spoke about the importance of cash. & Money. Keynesian economic theory states that both the state (government) and private sectors play an important role in the health of an economy. At a very practical level we own cash investments to pay for our daily or monthly investments provide a return to their holders.after which Keynesian economics or Keynesian Theory is named. or motives. Pay back Period: . Asset or Speculative Motive . is a relatively safe investment. Precautionary Motive . cash provides an investor with a way to control risk as well as gain a return on their investment. It is useful for conducting our everyday transactions or purchases. Reasons for Holding Cash Perhaps the best explanation for holding cash in a portfolio was summarized by John Maynard Keynes . In particular. Keynes outlined three reasons. Finally. 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. for holding money or cash: • • • Transaction Motive . we'll finish up with an outline of the various cash funds you can own as part of your investment portfolio.

The term internal refers to the fact that its calculation does not incorporate environmental factors (e. 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).g. because it does not properly account for the time value of money. It intuitively measures how long something takes to "pay for itself. Payback period does not specify any required comparison to other investments or even to not making an investment. maintenance. a $1000 investment which returned $500 per year would have a two year payback 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." payback period has no explicit criteria for decision-making (except. When used carefully or to compare similar investments. or other changes. often with respect to energy efficiency technologies. It is also called the discounted cash flow rate of return (DCFROR) or simply the rate of return (ROR). Whilst the time value of money can be rectified by applying a weight average cost of capital discount. Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most individuals. Payback period is widely used due to its ease of use despite recognized limitations. Alternative measures of "return" preferred by economists are net present value and internal rate of return. Here. IRR: The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. a compact fluorescent light bulb may be described of having a payback period of a certain number of years or operating hours. The expression is also widely used in other types of investment areas. the concept of a payback period is occasionally extended to other uses. As a stand-alone tool to compare an investment with "doing nothing. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period.[1] In the context of savings and loans the IRR is also called the effective interest rate.. described below. For example. it is generally agreed that this tool for investment decisions should not be used in isolation. the return to the investment consists of reduced operating costs. perhaps. upgrades. these other terms may not be standardized or widely used. that the payback period should be less than infinity). 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. it can be quite useful. regardless of academic training or field of endeavour." Shorter payback periods are obviously preferable to longer payback periods (all else being equal). The payback period is considered a method of analysis with serious limitations and qualifications for its use. assuming certain costs. Although primarily a financial term. the interest rate or inflation). risk. . financing or other important considerations such as the opportunity cost.

cash flow) pairs (n. . the total number of periods N. 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 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.In more familiar terms. 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.g. the internal rate of return is given by r in: Note that the period is usually given in years. In the case that the cash flows are random variables. quality.e. an investment whose IRR exceeds its cost of capital adds value for the company (i. the value of r cannot be found analytically. but the calculation may be made simpler if r is calculated using the period in which the majority of the problem is defined (e. This is in contrast with the net present value. such as in the case of a life annuity. cash flow) involved in a project.g. the IRR of an investment is the interest rate at which the costs of the investment lead to the benefits of the investment. and the net present value NPV. Given the (period. Note that any fixed time can be used in place of the present (e. the end of one interval of an annuity). An investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return. which is an indicator of the value or magnitude of an investment.. using months if most of the cash flows occur at monthly intervals) and converted to a yearly period thereafter. In this case. numerical methods or graphical methods must be used. In a scenario where an investment is considered by a firm that has equity holders. Calculation Given a collection of pairs (time. Often. it is an indicator of the efficiency. or yield of an investment. This ensures that the investment is supported by equity holders since. it is profitable). the value obtained is zero if and only if the NPV is zero. Uses Because the internal rate of return is a rate quantity. Cn) where n is a positive integer. in general.. the expected values are put into the above formula.

where rn is considered the nth approximation of the IRR.NPV0) and (r1.NPV1). there are many numerical methods that can be used to estimate r. then iterations of the formula can continue indefinitely so that r can be found to an arbitrary degree of accuracy. the answer is 14. This formula initially requires two unique pairs of estimations of the IRR and NPV (r0. [edit] Numerical solution Since the above is a manifestation of the general problem of finding the roots of the equation NPV(r). using the secant method. r is given by . If the sequence converges. and produces a sequence of that may converge to as . In this case. .3%. For example.Example If an investment may be given by the sequence of cash flows Year ( n) 0 1 2 3 4 Cash Flow (Cn) -4000 1200 1410 1875 1050 then the IRR r is given by .

Having when NPV or when NPV0 < 0 may speed up convergence of rn to r. then the sequence will If the function • converge to one of the roots and changing the values of the initial pairs may change the root to which it converges.The convergence behaviour of the sequence is governed by the following: • • NPV(i) has a single real root r. Project 'A' has a higher NPV (for certain discount rates). If the function NPV(i) has n real roots . If function NPV(i) has no real roots. NPV vs discount rate comparison for two mutually exclusive projects. then the sequence will converge reproducibly towards r. but only to decide whether a single project is worth investing in. the calculated IRR should not be used to rate mutually exclusive projects. even though its IRR (=x-axis intercept) is lower than for project 'B' (click to enlarge) . [edit] Problems with using internal rate of return As an investment decision tool. then the sequence will tend towards infinity.

so a high rate of return is best.. usually equal to the project's cost of capital. 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 applies for example when a customer makes a deposit before a specific machine is built. Apparently. Sturm's theorem can be used to determine if that equation has a unique real solution. so then one owes money. especially for high IRR projects. as these strategies usually require several cash investments throughout the project. 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). where there is usually a large cash outflow at the end of the project. but then receives more than one possesses. it should not be used to compare projects of different duration. one initially invests money. but only see one cash outflow at the end of the project (e. This presents a problem. the first project may have a lower IRR (expected return). the IRR can be calculated by solving a polynomial equation. MIRR is used. with equally attractive prospects. In general. Since IRR does not consider cost of capital. in which to invest the interim cash flows. In this case a discount rate may be used for the borrowing cash flow and the IRR calculated for the investment cash flow. In the case of positive cash flows followed by negative ones (+ + . like in the example 0% as well as 10%.g.[2] Accordingly. Therefore. When the calculated IRR is higher than the true reinvestment rate for interim cash flows. via IPO or M&A). In general the IRR equation cannot be solved analytically but only iteratively. Examples of this type of project are strip mines and nuclear power plants. -11). since there is frequently not another project available in the interim that can earn the same rate of return as the first project. so now a low rate of return is best. the measure will overestimate — sometimes very significantly — the annual equivalent return from the project. 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. but a higher NPV (increase in shareholders' wealth) and should thus be accepted over the second project (assuming no capital constraints). In a series of cash flows like (-10. There may even be multiple IRRs for a single project.. In this case it is not even clear whether a high or a low IRR is better.In cases where one project has a higher initial investment than a second mutually exclusive project. managers find it easier to compare investments of different sizes in terms of . When a project has multiple IRRs it may be more convenient to compute the IRR of the project with the benefits reinvestmented. which has an assumed reinvestment rate. 21. [2] This makes IRR a suitable (and popular) choice for analyzing venture capital and other private equity investments. The formula assumes that the company has additional projects. Despite a strong academic preference for NPV. surveys indicate that executives prefer IRR over NPV [3].-) the IRR may have multiple values.

(-1. This function is continuous. Although the NPV-function itself is not necessarily monotonically decreasing on its whole domain. 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. NPV remains the "more accurate" reflection of value to the business. where r is the rate of return. so there is a unique rate of return for which it is zero. [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%). Therefore. it is at the IRR. the NPV is a quadratic function of 1/(1+r). if the first and last cash flow have a different sign there exists an internal rate of return. 1. However. • Extended Internal Rate of Return: The Internal rate of return calculates the rate at which the investment made will generate cash flows. with discontinuities for cash flows. This method is convenient if the project has a short duration. a rate of return that results in the correct value of zero after the last cash flow). a quadratic function of the discount rate r/(1+r). Hence the IRR is also unique (and equal). IRR. and towards a rate of return of positive infinity the net present value approaches the first cash flow (the one at the present). the highest NPV is -0. Thus internal rate(s) of return follow from the net present value as a function of the rate of return. The resulting function of the rate of return is continuous and monotonically decreasing from positive infinity to negative infinity. in the case of a series of exclusively positive cash flows followed by a series of exclusively negative ones the IRR is also unique. for r = 100%. when comparing mutually exclusive projects. Does inclusion of debt create value for the company? . but for projects which has an outlay of many years this method is not practical as IRR ignores the Time Value of Money. 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. or put differently. In the case of a series of exclusively negative cash flows followed by a series of exclusively positive ones. Towards a rate of return of -100% the net present value approaches infinity with the sign of the last cash flow. as a measure of investment efficiency may give better insights in capital constrained situations. NPV is the appropriate measure. However. -1).percentage rates of return than by dollars of NPV.75. Examples of time series without an IRR: • • Only negative cash flows .the NPV is negative for every rate of return. Similarly. rather small positive cash flow between two negative cash flows. This method of calculation of IRR is called Extended Internal Rate of Return or XIRR. consider the total value of the cash flows converted to a time between the negative and the positive ones.

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

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