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Introduction:

When investment proposals are considered individually, any

of the DCF criteria- NPV, IRR, or BCR – may be applied

for obtaining a correct “accept or reject” signal.

However, in the existing organization, capital investment

projects often cannot be considered individually or in

isolation as project independence, lack of rationing and

project divisibility are rarely fulfilled. So it is proposed to

discuss the problems with the method of ranking, and other

techniques to be employed to select the capital budget in

face of constraints.

13. Constraints:

Projects are economically independent, if the acceptance or

rejection of one does not change the cash flow stream or does

not affect the acceptance or rejection of the other. But, the

projects are dependent, if these conditions are not fulfilled.

Mutually exclusive projects substitutes for each other.

Even though the projects are not mutually exclusive, they

influence negatively each other’s cash flows if they are

accepted together.

Positive economic dependency occurs when there is

complementarity between projects. These can be

asymmetric or symmetric.

Capital Rationing:

When funds available for investment are inadequate to

undertake all projects which are otherwise acceptable,

capital rationing exists. Reasons are:

i ) Internal limitation or external limitation

ii) Set a limit to the capital expenditure outlays

iii) A choice of hurdle rate higher than the cost of

capital of the firm

iv) Inability to raise sufficient amounts of funds

at a given cost of capital.

The implication of rising capital supply is that some projects would be

postponed or abandoned if the cost of capital tends to increase.

Behaviour of Cost of Capital

Cost of Capital

Project Indivisibility:

A capital project has to be accepted or rejected in toto- a

project cannot be accepted or rejected partially.

Given the indivisibility of capital projects and the existence

of capital rationing, the need arises for comparing projects.

An example will illustrate the indivisibility.

Example: A firm is evaluating three projects A, B, and C

which have the following data. The funds available to the

firm for investment are Rs. 0.7 million.

Project Capital Outlay NPV

A Rs. 0.5 million Rs. 0.2 million

B Rs. 0.4 million Rs. 0.15 million

C Rs. 0.3 million Rs. 0.1 million

In this situation, acceptance of project A which yields

a NPV of Rs. 0.2 million results in rejection of projects

B and C which together would yield a combined NPV

of Rs. 0.25 million. Hence, because of the indivisibility of

projects, there is a need for the comparison of projects

before the acceptance/rejection decisions are taken.

2. Methods of Ranking

Because of economic dependency, capital rationing, or

project indivisibility, a need arises for comparing projects

in order to take a decision of acceptance or rejection.

Basically two approaches are available:

(i) the method of ranking, and

(ii) the method of mathematical programming

The method of ranking consists of two steps:

(i) Rank all projects in a decreasing order according to their

individual NPV’s , IRR’s, or BCR’s.

(ii) Accept projects in that order until the capital budget is

exhausted.

The method of ranking, originally proposed by Joel Dean is

seriously impaired by two problems:

(i) conflict in ranking as per DCF criteria, and (ii) project

indivisibility.

Conflict in Ranking:

Consider a set of five projects, A, B, C, D, and E, for which

the following information is available.

Project Investment Annual Cash Flow Project life

(Rs.) (Rs.) (years)

A 10,000 4,000 12

B 25,000 10,000 4

C 30,000 6,000 20

D 38,000 12,000 16

E 35,000 12,000 9

The NPV, IRR, and BCR for the five projects and the

ranking along these dimensions are shown below:

Project NPV NPV IRR IRR BCR BCR

(Rs.) Ranking % Ranking Ranking

A 14,776 4 39 1 2.48 1

B 5,370 5 22 4 1.21 5

C 14,814 3 19 5 1.49 4

D 45,688 1 30 2 2.20 2

E 28,936 2 29 3 1.83 3

If there is no capital rationing, all the projects would be

accepted under all the three criteria though internal

ranking may differ across criteria. However, if the funds

available are limited, the set of projects accepted would

depend on the criteria adopted.

What causes ranking conflicts? Ranking conflicts are

traceable to differing assumptions made about the rate

of return at which intermediate cash flows are re-invested.

Project Indivisibility

A problem in choosing the capital budget on the basis of

individual ranking arises because of indivisibility of capital

expenditure projects. To illustrate, consider the following

set of projects ( ranked according to their NPV ) being

evaluated by a firm which has a capital constraint of

Rs. 2,500,000.

Project Outlay (Rs.) NPV (Rs.)

A 1,500,000 400,000

B 1,000,000 350,000

C 800,000 300,000

D 700,000 300,000

E 600,000 250,000

If the selection is based on individual NPV ranking, projects

A and B would be included in the capital budget – these

projects exhaust the capital budget. A cursory examination,

however, would suggest that it is more desirable to select

projects B, C, and D. These three projects can be

accommodated within the capital budget and have a

combined NPV of Rs. 850,000 which is greater than the

combined NPV of A and B.

Feasible Combination Approach:

The above example suggests that the following procedure

may be used for selecting the set of investments under

capital rationing.

(This procedure can also take care of project interdependency)

1. Define all combinations of projects which are feasible,

given the capital restriction and project interdependencies.

2. Choose the feasible combination that has the highest NPV

Illustration

Project Outlay(Rs.) NPV(Rs.)

A 1,800,000 750,000

B 1,500,000 600,000

C 1,200,000 500,000

D 750,000 360,000

E 600,000 300,000

Projects B and C are mutually exclusive. Other projects

are independent.

Given the above information, the feasible combinations and

their NPV s are shown below:

Feasible Outlay NPV

combination (Rs.) (Rs.)

A and B 3,000,000 1,250,000

A and D 2,550,000 1,110,000

A and E 2,400,000 1,050,000

B and D 2,250,000 960,000

B and E 2,100,000 900,000

C and D 1,950,000 860,000

C and E 1,800,000 800,000

B, D and E 2,850,000 1,260,000

C, D and E 2,550,000 1,160,000

The most desirable feasible combination consist of projects

B, D and E as it has the highest NPV.

3. Mathematical Programming Approach

The feasible combinations described above becomes

increasingly cumbersome as the number of projects

increases and as the number of years in planning horizon

increases. To cope with a problem of this kind, it is helpful

to use mathematical programming models. The advantage

of mathematical programming models is that they help in

determining the optimal solution without explicitly

evaluating all feasible combinations.

A mathematical programming model is formulated in terms

of two broad categories of equations: ( i ) the objective

function (ii) the constraint equations.

Both are defined in terms of parameters and decision

variables. Parameters represent the characteristics of the

decision environment which are given. Decision variable

represents what is to control by decision makers.

Out of wide variety of mathematical programming models,

three types are usually used.

Linear programming model

Integer programming model

Goal programming model

4. Linear Programming Model

Assumptions:

• The objective function and the constraint equations are

linear.

• All the coefficients in the objective function and constraint

equations are defined with certainty.

• The objective function is unidimensional.

• The decision variables are considered to be continuous.

• Resources are homogeneous.

5. Integer Linear Programming Model

The principal motivation for the use of integer linear

programming approach are:

a) It overcomes the problem of partial projects which besets

the linear programming model as it permits only 0 or 1

value for the decision variables.

b) It is capable of handling virtually any kind of project

interdependency.

It may be noted that the only difference between the linear

integer programming model and the basic linear

programming model is that the first one ensures that a

project is either completely accepted or completely

rejected.

The following kinds of project interdependencies can be

incorporated in the integer linear programming model:

o Mutual exclusiveness

o Contingency

o Complementariness

6. Goal programming Model

The goal programming approach, a kind of mathematical

programming approach, provides a methodology for

solving an optimization problem that involves

multiple goals. To use the goal programming model, the

decision makers must:

1. State an absolute priority order among his goals.

2. Provide a target value for each of his goal.

It seeks to solve the programming problem by minimizing

the absolute deviations from the specific goals in order of

the priority structure established. Goals at priority level

one are sought to be optimized first. Only when this is done

will the goals at priority level two be considered ; so on and

so forth. At a given priority level, the relative importance

of two or more goals is reflected in the weights assigned to

them.

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