Corporate Finance

AF4801

LECTURE 03

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 Capital Rationing
Capital Rationing

• Ideally firm will continue to invest in positive return NPV projects until the marginal returns equal to
marginal cost of capital.
• Should a firm have insufficient capital to do this, it must ration its capital among the best possible
combination of acceptable projects.

Hard Capital Rationing occurs when the fund allocated to managers under the capital budget cannot be
increased.

Soft Capital Rationing occurs when manager are allowed to increase their allocated capital budget if they can
justify to senior management that the additional funds will create shareholder value.

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Example:

Project Analysis to Mayco

Investment Outlay NPV

-800 300
Project A
-500 180
Project B
-400 100
Project C
-350 85
Project D

-300 -50
Project E

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 Effects of Inflation in Capital Budgeting Analysis
Inflation is a complication that must be considered as part of the capital budgeting process.

Analyzing nominal and real cash flows: Nominal cash flows reflects the impact of inflation, while real cash flows are
adjusted downward to remove inflation effects, Although either type of cash flows can be used in capital budgeting process.
It is important to match the type of cash flow with the discount rate.

Changes in Inflation affect project profitability: If inflation is higher than expected future project cash flows are worth less
and the value of the project will be lower than expected. The opposite is also true.

Inflation reduces the tax savings from depreciation: If inflation is higher than expected, the firm’s real taxes paid to the
government are effectively increased because the depreciation tax shelter is less valuable. This is because the depreciation
charge, which is based upon the asset’s purchase price, is less than it would be calculated if recalculated at current prices.

Inflation decreases the value of payments to bondholders: Bondholders receive fixed payments that are effectively
worthless if inflation increases.

Inflation may effects revenue and cost differently: If prices of goods change at different rate than the prices for inputs used
to create those goods, the firm after tax cash flows may
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be better or worse than expected.
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 Types of Real Options and Evaluate a Capital project using real Option
Real options allow managers to make future decisions that change the value of a capital budgeting decisions
made today. Real Options are similar to financial call and put option in that they give the option holder the
right, but not the obligation, to make a decision. The difference is that they are based on real assets rather than
financial assets.

Types of Real Options

• Timing Options allow a company to delay making an investment with the hope of having better information
in the future
• Abandonment Options are similar to put options. They allow management to abandon a project if PV on
incremental cash flows from exiting a project exceeds the PV of the incremental cash flows from continuing
a project.
• Expansion Options are similar to call options, Expansion options allow a company to make additional
investments in a project if doing so creates value.
• Flexibility Options gives managers a choice regarding the operational aspect of a projects. The two main
form are price –setting and production flexibility.
• Fundamental Options are projects that are options themselves because the payoffs depend on the price of
underlying asset.
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Approaches of evaluating the profitability of an investment with real options
Using Decision Trees for Real Option Analysis

Valuing real options, such as expansion options and abandonment options, must be done with the use of decision
trees, as their value cannot be determined via the Black-Scholes formula. Real options represent actual decisions a
company may make, such as whether to expand or contract operations. For example, an oil and gas company can
purchase a piece of land today, and if drilling operations are successful, it can cheaply buy additional lots of land. If
drilling is unsuccessful, the company will not exercise the option and it will expire worthless. Since real options
provide significant value to corporate projects, they are an integral part of capital budgeting decisions.

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Approaches of evaluating the profitability of an investment with real options
Calculate the project NPV without option and add the estimated value of real options:

Overall NPV = Project NPV – option cost +option value

Example:
Black Pearl Yachts estimated that the NPV of the expected cash flows from a new production facility to produce
Classic Yachts if negative $8 million. Black Pearl’s production manager is evaluating an additional investment of $5
million in equipment that would give management a flexibility to switch between Classic, Deluxe & Elite models of
yachts depending on demand. The option to switch production among model of yachts is estimated to have a value
of $15 million. Evaluate the profitability of the project, including the real option.

Solution:
Overall NPV = -$8million - $ 5million + $ 15million = $ 2million.

Without the option, the NPV of the production facility is negative. However, the real options add enough value to
make the overall project profitable.

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Approaches of evaluating the profitability of an investment with real options
Example: Abandonment Project
3 year project with a project cost of capital is 14%. The initial investment is $1,000 and the expected cash flows are
$400. Suppose, we have more information on the expected cash flows, First there is a 50% probability that the cash
flow will be $200 and 50% probability that the cash flow will be $600. In addition at the end of the first year we will
know whether the project is a success or failure and we have the option to abandon the project at the end of first
year and receive the salvage value of $650.

First Determine the optimal abandonment strategy. Then calculate the projects NPV and the value of abandonment
option using that strategy.

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Approaches of evaluating the profitability of an investment with real options
Solution:
Strategy:
By abandoning the project, we receive the salvage value of $650 but give up the cash flows in year 2 and 3.
Therefore, the optimal strategy is to abandon the project at the end of the first year if the present value of
remaining cash flow in year 2 and 3 is less than salvage value.
If the project is success, the cash flows will be $600 in years 2 and 3 and present value of those cash flows at the
end of year 1 is $988 which is greater than salvage value.so the optimal strategy is to not abandon the project.
If the project is failure, the cash flow will be received in year 2 & 3 will only be $ 200. The present value drops to $
329 which is less than the salvage value of $ 650, so if the project is failure , the optimal strategy to abandon the
project.
NPV in Success = $393
NPV in failure = -$254
The projects expected present value with the abandonment option is:
NPV = 0.5(393) + 0.5(-254) = $69.50
The Value of the option is:
Value of abandonment option = 69.50 – (-71.35)= $140.85

25/10/2022 Syed Muhammad Ali Raza