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Chapter 22 -- Capital Rationing

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.

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Chapter 22 -- Capital Rationing

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  1. 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

  2. Reasons for Capital Rationing • Management policy • Common practice – 72% of companies • Tool for allocating funds in support of strategy • Control problems if more securities are sold • Limit risk by limiting growth

  3. Reasons for Capital Rationing • Management policy (continued) • Belief 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

  4. 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

  5. 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

  6. Multi-period Capital Rationing • Allocate capital so as to maximize wealth as of the end of the capital rationing period (TWc) c nTWc = CFt(1+Rt)c-t + CFt/(1+k)t-c – I0(1+R0)t t=1 t=c+1Where 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.

  7. 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) = nNPVR = CFt/(1+R)t – I0t=1Where R is the reinvestment opportunity rate

  8. 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

  9. Profitability Index and Capitial Rationing • Useful only for single-period rationing

  10. 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

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