Lecture (14)

Feasibility
[Chapter (8) Capital rationing]

-In the previous chapters we explain the following points:-

(1) Neither of payback nor ROCE/ARR were satisfactory investment

appraisal rules as they did not lead to the firm optimally locating onto
the physical investment line.
(2) Both the DCF techniques (NPV and IRR) did lead the firm to locate
optimally.
(3) Closer examination of the IRR method uncovered a number of
problems with its use.
(4) We concluded that the NPV decision rule was the only investment
appraisal technique would lead to investment decisions which maximize
shareholders wealth. Although NPV technique assumes the existence of
the perfect capital market.
-In this chapter we will discuss NPV in the absence of perfect capital
market. In particular when the company may not able to undertake all
positive NPV projects because of a shortage of capital investment funds
which is known as capital rationing (management will not find funds).

*Capital market borrowing:-

There is no general agreement on what precisely is meant by the term
(capital rationing). Here we define capital rationing as a managerial
problem. It is a theoretical problem for our decision making model, but
more importantly, it is also a practical problem.
As we have seen, the NPV decision rule is: accept all projects with cash
flows which, when discounted by the market interest rate, have a
positive or zero NPV.
-Implicit in the NPV decision rule, is the idea that as long as company’s
management can find investments opportunities that yield at least the
capital market return, then capital will be available to finance these
projects. In the perfect capital market if the company’s resources are not
enough, then it can borrow to undertake the project, since the cash
inflows resulted from the project will sufficient to repay the loan and
the interest to leave profit to shareholders.