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Chapter 22 -- Capital Rationing
Capital
Market imposed capital rationing
Intersects the cost of capital line at a
vertical point due to information
asymmetry
Investors simply may not be willing to
provide more money to the company
because they do not believe more growth
is good
Reasons for Capital Rationing
Management
policy
practice – 72% of companies
Tool for allocating funds in support of
strategy
Control problems if more securities are sold
Limit risk by limiting growth
Common
Reasons for Capital Rationing
Management
Belief
policy (continued)
that competition forces the best
projects to the top of the heap
Uncertainty about the actual cost of capital
Surrogate for dealing with other scarce
resources, such as management talent
Capital Rationing and NPV
Use
the rate over the constrained period
and then the cost of capital
When NPV conflicts with IRR use the
NPV method
Single-period Capital Rationing
No
capital rationing expected after this year’s
selections are made
Wealth maximization rule is to allocate scarce
capital so as to maximize total NPV using the
standard NPV evaluation methods
Multi-period Capital Rationing
Allocate
capital so as to maximize wealth as of
the end of the capital rationing period (TWc)
c
n
TWc = CFt(1+Rt)c-t + CFt/(1+k)t-c – I0(1+R0)t
t=1
t=c+1
Where c is the number of periods of capital
rationing, CFt is cash flow in period t, Rt is the
reinvestment opportunity rate for period t, k is
the required return (WACC), and I0 is the
initial investment.
Multiperiod Capital Rationing
If
capital rationing will last as long as proposed
investments, cost of capital will remain constant,
and reinvestment opportunity rate will remain
constant, NPV with capital rationing (NPVR) =
n
NPVR = CFt/(1+R)t – I0
t=1
Where R is the reinvestment opportunity rate
IRR Rankings in Capital
Rationing
IRR
ranking will lead to correct selection if
capital rationing will last as long as the proposed
investment, R will be the same each period, and
will exceed the cost of capital, and R is the rate
of return on the highest rejected investment.
Multiple IRRs
Dorfman
shows that if the project has more than one
IRR, the highest IRR is the rate at which capital will
grow
Profitability Index and Capitial
Rationing
Useful
only for single-period rationing
Mutually Exclusive Projects and
Capital Rationing
General
solution requires mathematical
programming
If the company has enough capital this period to
accept all investments above the internal
reinvestment rate, R, the problem can be
simplified to maximizing NPV using R as the
discount rate