Ranking Investment Projects Flashcards
What is the concept of Capital rationing?
Ranking investment projects
Capital rationing exists when a firm sets a limit on the amount of funds to be invested during a given period. In such situations, a firm cannot afford to undertake all profitable projects
Another way of stating this is that the firm cannot invest the entire amount needed to fund its theoretically optimal capital budget
Only those projects that will return the greatest NPV for the limited capital available in the internal capital market can be undertaken
What are reasons for capital rationing?
Ranking investment projects
Reasons for capital rationing include:
- A lack of nonmonetary resources (i.e. managerial or technical personnel)
- A desire to control estimation bias (overly favorable projections of a project’s cash flows)
- An unwillingness to issue new equity (i.e. because of its cost or a reluctance to reveal data in regulatory filings)
What is a Profitability index?
The profitability index (or excess present value index) is a method for ranking projects to ensure that limited resources are placed with the investments that will return the highest NPV:
Profitability index = NPV of future cash flows / Net investment
Note: On the CMA exam, the profitability index may be calculated one of two ways - with the numerator as the PV of either all cash flows or of only the cash inflows. The calculation of the numerator does not affect the choice of the most profitable project
What is Internal capital market
Ranking investment projects
Internal capital market is a way of referring to the provision of funds by one division of a firm to another division. A division operating in a mature industry that generates a lot of cash can provide funding to another division that is in the cash-hungry development stage
Advantage - the avoidance of stock issue costs or interest costs on new debt
Disadvantage - calling it a “market” is somewhat misleading. The dynamics of the process are more akin to centralized planning and budgeting than to the workings of a free marketplace
What is Linear programming?
Ranking investment projects
Linear programming is a technique (now usually computerized) for optimizing resource allocations so as to select the most profitable or least costly way to use available resources
It involves optimizing an objective function subject to the net of constraint equations (i.e. a linear programming application can maximize NPV for a group of projects in a capital rationing situation - expenditure constraint)
