For each of the selection criteria previously discussed, the decision rule is to undertake all independent investment projects that meet the acceptance standard. This rule places no restrictions on the total amount of acceptable capital projects a company may undertake in any particular period.
However, many firms do not have unlimited funds available for investment. Rather than letting the size of their capital budget be determined by the number of profitable investment opportunities available, many companies choose to place an upper limit, or constraint, on the amount of funds allocated to capital investments.
This constraint may be either self-imposed by the firm’s management or externally imposed by conditions in the capital markets. For example, a very conservative firm may be reluctant to use debt or external equity to finance capital expenditures. Instead, it would limit capital expenditures to cash flows from continuing operations minus any dividends paid. Another firm may feel that it lacks the managerial resources to successfully undertake all acceptable projects in a given year and may choose to limit capital expenditures for this reason.
A number of externally imposed constraints might limit a firm’s capital expenditures. For example, a firm’s loan agreements may contain restrictive covenants that limit future borrowing. Similarly, a weak financial position, conditions in the securities markets, or both may make the flotation of a new bond or stock issue by the firm impossible or prohibitively expensive. Examples of such market -imposed constraints include depressed stock market prices, unusually high interest rates due to a “tight money” policy on the part of the Federal Reserve System, and a reluctance on the part of investors to purchase new securities if the firm has a large percentage of debt in its capital structure. Several different methods can be used in making capital budgeting decisions under capital rationing.
When the initial outlays occur in two (or more) periods, the methods are quite elaborate and require the use of linear, integer, or goal programming. However, when there is a single-period capital budgeting constraint, a relatively simple approach employing the profitability index can be used. Briefly, the approach consists of the following steps:
Step 1: Calculate the profitability index for each of a series of investment projects.
Step 2: Rank the projects according to their profitability indexes (from highest to lowest).
Step 3: Beginning with the project having the highest profitability index, proceed down through the list, and accept projects having profitability indexes greater than or equal to 1 until the entire capital budget has been utilized.
At times, a firm may not be able to use its entire capital budget because the next acceptable project on its list is too large, given the remaining available funds. In this case, the firm’s management should choose among the following three alternatives:
Alternative 1: Search for another combination of projects, perhaps including some smaller, less profitable ones that will allow for a more complete utilization of available funds and increase the net present value of the combination of projects.
Alternative 2: Attempt to relax the funds constraint so that sufficient resources are available to accept the last project for which funds were not fully available.
Alternative 3: Accept as many projects as possible and either invest any excess funds in short-term securities until the next period, pay out the excess funds to shareholders as dividends, use the funds to reduce outstanding debt, or do a combination of the above.
The following example illustrates how these alternatives can be applied to an actual capital budgeting decision. Suppose that management of the Old Mexico Tile Company has decided to limit next year’s capital expenditures to $550,000. Eight capital expenditure projects have been proposed—P, R, S, U, T, V, Q, and W—and ranked according to their profitability indexes, as shown in Table. Given the $550,000 ceiling, the firm’s management proceeds down the list of projects, selecting P, R, S, and U, in that order. Project T cannot be accepted because this would require a capital outlay of $25,000 in excess of the $550,000 limit.
Projects P, R, S, and U together yield a net present value of $114,750 but require a total investment outlay of only $525,000, leaving $25,000 from the capital budget that is not invested in projects. Management is considering the following three alternatives:
Old Mexico Tile Company: Ranking of Proposed Projects According to Their Profitability Indexes
Alternative 1: It could attempt to find another combination of projects, perhaps including some smaller ones, that would allow for a more complete utilization of available funds and increase the cumulative net present value. In this case, a likely combination would be Projects P, R, S, T, and V. This combination would fully use the $550,000 available and create a net present value of $116,250—an increase of $1,500 over the net present value of $114,750 from Projects P, R, S, and U.
Alternative 2: It could attempt to increase the capital budget by another $25,000 to allow Project T to be added to the list of adopted projects.
Alternative 3: It could merely accept the first four projects—P, R, S, and U—and invest the remaining $25,000 in a short-term security until the next period. This alternative would result in an NPV of $114,750, assuming that the risk adjusted required return on the short-term security is equal to its yield.
In this case, Alternative 1 seems to be the most desirable of the three. In rearranging the capital budget, however, Old Mexico Tile Company should never accept a project, such as W, that does not meet the minimum acceptance criterion of a positive or zero net present value (a profitability index greater than or equal to 1).
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Financial Management Tutorial
The Role And Objective Of Financial Management
The Domestic And International Financial Marketplace
Evaluation Of Financial Performance
Financial Planning And Forecasting
The Time Value Of Money
Risk And Return On At&t Common Stock
Fixed-income Securities: Characteristics And Valuation
Common Stock: Characteristics,valuation, And Issuance
Capital Budgeting And Cash Flow Analysis
Capital Budgeting: Decision Criteria And Real Option Considerations
Capital Budgeting And Risk
The Cost Of Capital
Capital Structure Concepts
Capital Structure Management In Practice
Working Capital Management
The Management Of Cash And Marketable Securities
Management Of Accounts Receivable And Inventories
Lease And Intermediate-term Financing
Financing With Derivatives
Internationan Financial Management
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