Lecture 5 - Asset Investment Decisions and Capital Rationing

Question 1

Shareholder wealth is maximised if a company…

Answer 1

Maximises all possible positive NPV projects.

Question 2

Capital rationing is when…

Answer 2

There are insufficient funds to finance projects.

Question 3

Capital rationing can be…

Answer 3

Single or multi period.

Question 4

What is hard capital rationing?

Answer 4

An absolute limit on the amount of finance available is imposed by the lending institutions. This is due to external factors and there is nothing that can influence this.

Question 5

What is soft capital rationing?

Answer 5

A company (top management) may impose its own rationing on capital. This is due to internal factors.

Question 6

What are the reasons for hard capital rationing?

Answer 6

• Industry wide factors limiting funds.
• Company specific factors.
• Lack of or poor track record.
• Lack of asset security. For example, a new start up technology firm may have more intangible assets like research and development instead of tangible assets like an airline company would have. This may mean it would be more difficult for them to get external financing from a bank.
• Poor management team.
• Costly.

Question 7

What are the reasons for soft capital rationing?

Answer 7

• Limited management skills available.
• Desire to maximise return of a limited range of investments.
• Encourage acceptance of only substantially profitable business.

Question 8

What are the problems with the Profitability Index method ?

Answer 8

• Cannot be used if projects are indivisible (i.e. must be done entirely or not at all) and resources are not fully exhausted.
• Is of limited use for multi period capital rationing when projects have different cash flow patterns.
• Is fairly simplistic, taking no account of the possible strategic value of individual investments in the context of the overall objectives of the organisation.
• Ignores the absolute size of individual projects.

Question 9

Mutually exclusive are projects which…

Answer 9

Usually serve the same purpose. Firms should only choose one project.

Question 10

How do we compare mutually exclusive projects?

Answer 10

Using NPV. Project with the highest NPV should be chosen.

Question 11

What are the problems associated with mutually exclusive projects?

Answer 11

• The investment timing problem.
• The choice between long and short lived equipment.
• The replacement problem.

Question 12

Today’s investment is competing with…

Answer 12

Possible future investments.