Lecture (15)

Feasibility
-The term ‘capital rationing’ refers to the situation where the implicit
assumption within the NPV rule, that capital will always be available to
finance acceptable projects, does not hold.
That is if management cannot raise enough money from the capital
market, then a situation of capital rationing will exist. The management
has to ‘ration out’ the limited amount of investment capital between
the available projects.
-The capital rationing will not exist if management can raise enough
money from banks and financial institutions, but also exists if
the shareholders of the company are not willing to pay more money in
terms of new shares.
(The company can raise the funds internally by the shareholders or
externally through banks and financial institutions.)
-The existence of capital rationing represents a capital market
imperfection: investment funds are no longer freely available at the
market rate of return.
-Given a situation of capital rationing, how does it affect the efficiency
of investment decision advice given by the NPV appraisal technique,
and can NPV be adapted to operate successfully in such situations?
*Hard and soft capital rationing:-
-Hard capital rationing describes the situation where forces external to
the company, usually either the capital market itself or the government
will not supply unlimited amounts of investment capital to a company,
even though the company has identified investment opportunities that
would be able to produce the required return.
-Soft capital rationing arises from forces internal to a company, such
as a capital budget, which limits the amount of capital available for
investments.
Example: Suppose a company has two independent projects (G)
and (H). Both projects required $1000 of investment capital, and
project (G) yields 14% return, whereas project (H) yields 16% return. If
the- company’s cost of capital is 12% and funds are unlimited.
-In this case we will accept both projects because both projects will
produce positive NPV
, but if funds are limited that the company can provide $1000 only
(capital rationing), then the company has to choose between the two
projects to choose the project which produces higher NPV, then
compare between the return of the chosen project and the alternative
return of the capital market.
-To choose among the two situations (unlimited capital and capital
rationing) as follows:-
Unlimited capital Capital rationing

Step 1: Choose or reject Compare between projects

project (G) (G) and (H)

Step 2: Choose or reject Compare between the return

project (H) of the chosen project and
the capital market return

independent steps dependent steps (sequential

steps)

*Single period capital rationing:-

-We will assume a soft rationing situation, but the conclusions we
derive will be equally applicable to hard rationing.
-The method is based on the following points:-
[1] It is assumed that capital is rationed at present (i.e. t0 or Y0) but will
be available in the future or that capital outlay of an project is required
in t0 or Y0 .
[2] Projects are divisible, so that the fractions of projects may be
undertaken.
Ex: If the company has $1200 as a capital and it will invest in
2 projects; project (A) which require $1000 and project (B) which
require $1000, project (A) has a higher profit. Then we will choose (A)
and the rest of $200 will use in 20% of project (B).
[3] They exhibit constant returns to scale.
( To compare with the constant for company)
[4]Compute NPV to each project using the market discount rate.
[5]Compute for each project a ratio of NPV to its capital outlay which is
called ‘Benefit-cost ratio’.
[6]Accept all projects with positive ratio or zero benefit-cost ratio.
[7]Rank projects starting with the project of the largest positive ratio
and down as many projects as possible with zero or positive ratio.
Example: Assume that Al-Gona Company has the following projects:-

Projects Year NPV discounted

0 1 2 3 4 at 12%

(A) - 120 +30 +70 +50 +40 +23.6

(B) - 80 +40 +55 +40 0 +28.04
(C) - 90 -10 +50 +60 +50 +15.42
(D) - 80 +20 +40 +30 +10 -2.53
 Lecture (16)
Feasibility
Example (1):-
Projects Year NPV discounted
0 1 2 3 4 at 12%

(A) - 120 +30 +70 +50 +40 +23.6

(B) - 80 +40 +55 +40 0 +28.04
(C) - 90 -10 +50 +60 +50 +15.42
(D) - 80 +20 +40 +30 +10 -2.53

-Perfect capital market:-

To choose among these projects, we will first calculate Benefit-cost
ratio as following:-
Benefit-cost ratio = NPV .
Y0 outlay

Project NPV ÷ Y0 outlay Benefit-cost Ranking

ratio
(A) +23.6 ÷ 120 +0.20 2
(B) +28.04 ÷ 80 +0.35 1
(C) +15.42 ÷ 90 +0.17 3
(D) -2.53 ÷ 80 - 0.03 ___

-We will suppose that capital rationing exists at Year 0 as a result that
a company has only capital outlay of $250

Project Ranking Outlay at

Year 0
(B) 1 $80
(A) 2 $120
(C) 3 $90
So we will accept Project (B) in full as it required in Year 0 $80
we will accept Project (A) in full as it required in Year 0 $120
we will accept part of project (C) $50
$250
Total NPV=28.04 + 23.6 + ( 50 × 15.42) = +60.21
 90

-The capital outlay should be applied to projects (B), (A), and part of
(C) and this give the company a total positive NPV of 60.21 which is
the maximum possible total NPV, given the capital expenditure
constraint.
-Therefore, because investment capital is scarce, shareholder wealth
will only rise by 60.21 as a result of investment decisions made.
-The process of selecting projects on the basis of their benefit-cost
ratios ensures that the company will maximize the total amount of
positive gained from the available projects, assuming limited
investment capital.
Example (2): we will assume two separate single period capital
rationing that:-
[1] In the first situation there is straightforward Year 0 rationing.
[2] In the second situation, some positive NPV projects may not be
accepted, but there could be circumstances where there could be
the advantage to accept negative NPV projects.
-Assuming Samar Company is considering the following projects:-
Years
Project 0 1 …….. NPV
(O) - 150 -200 …….. +15
(P) - 120 -100 …….. +33
(Q) - 90 -120 …….. +42
(R) - 200 -80 …….. -14
(S) - 70 +100 …….. +12
(T) - 180 +90 …….. -6
-Based on NPV criteria, management should accept all projects except
the projects (R) and (T).
-Samar management knows that there will be no capital rationing in
year 1, but in year 0 it is willing to expend only $350 in Year 0.
-To solve the problem of single time-period capital rationing situation
at Year 0, we will use benefit-cost ratio rankings as follows:-
Project NPV ÷ Y0 outlay Benefit-cost Ranking
ratio
(O) +15 ÷ 150 +0.1 4
(P) +33 ÷ 120 +0.28 2
(Q) +42 ÷ 90 +0.47 1
 (R) -14 ÷ 200 -0.07 ___
(S) +12 ÷ 70 +0.17 3
(T) -6 ÷ 180 -0.03 ___
NPV
Investment decision: 350 available
- 90 invested in project (Q), producing: +42
+260 Balance
- 120 invested in project (P), producing: +33
+140 Balance
- 70 invested in project (S), producing: +12
+70 Balance
-70 invested in (70) of project (O),producing: +7
0 150 +94

-Therefore, the company should undertake projects (Q), (P), (S), and part of (O).
This will generate a total positive NPV of +94 which will be the maximum
possible, even the expenditure constraint.