Chapter 6 B

Question 1

Capital rationing

Answer 1

a situation in which there is not enough finance (capital) available to undertake all available positive NPV projects. Therefore, capital has to be rationed

Question 2

Hard capital rationing

Answer 2

the capital markets impose limits on the amount of finance available.

Question 3

Soft capital rationing

Answer 3

the company sets internal limits on finance availability.

Question 4

Single period capital rationing

Answer 4

capital is in short supply in only one period.

Question 5

Multi period capital rationing

Answer 5

capital is rationed in one or two more periods

Question 6

Reasons for hard capital rationing

Answer 6

High business risk (i.e. the company’s operating cash flows are very sensitive to the economic cycle).
High country/political risk (i.e. there are concerns about corporate governance or state appropriation of assets).
High financial risk (i.e. the company already has high existing levels of debt).
Lack of reliable independent information available about the company. This is especially relevant to small– and medium–sized entities (SMEs).

Question 7

Reasons for soft capital rationing

Answer 7

A preference for slower organic growth to a sudden increase in size arising from accepting several large investment projects. This particularly applies in a family-owned business that wishes to avoid hiring new managers.
Managers may wish to avoid raising further equity finance if this will dilute the control of existing shareholders.
Managers may wish to avoid issuing new debt if their expectations of future economic conditions are such that an increased commitment to fixed interest payments would be unwise.
To create an internal market for investment funds. This can be seen as a way of reducing the risk and uncertainty associated with investment projects, as it leads to only accepting projects with greater margins of safety.

Question 8

Divisible project

Answer 8

A project is divisible if the company can make any partial or proportionate investment in it (i.e. between 0% and 100%). However, the project cannot be repeated.

Question 9

Steps for rationing capital to divisible projects

Answer 9

Calculate a profitability index for each project:
Profitability index = NPV/Capital investment.
Next, rank projects according to their index.
Then allocate funds to the most effective projects in order to maximise NPV.

Question 10

Steps for non divisible project

Answer 10

Do not calculate a profitability index.
Simply list all possible combinations of projects which can be utilised given the capital budget (limit).
Choose the combination with the highest NPV.

Question 11

Mutual.y exclusive projects

Answer 11

Mutually exclusive projects means that two or more particular projects cannot be undertaken at the same time (e.g. because they use the same land).

Question 12

Multi period capital rationing

Answer 12

If finance is limited in several periods, a linear programming model would have to be set up and be solved to find the optimal investment strategy.

Question 13

Steps in asset replacement decision

Answer 13

Calculate the NPV of each possible replacement cycle.
Calculate the equivalent annual cost (EAC) of each cycle:
EAC = NPV/Annuity factor
Choose the cycle with the lowest EAC

Question 14

Conventional cash flows

Answer 14

An initial cash outflow followed by a series of inflows when cash flows vary this is called non conventional and makes IRR harder to interpret. Eg cash inflows + cash outflows in the periods