Capital budgeting decision

Single period capital rationing:

Investment funds are limited in the current period and the financial manager’s concern is to maximize return by choosing a mix of investment opportunities. Single period capital rationing may occur in:

1. Divisible projects and

2. Indivisible projects.

 

Single period divisible projects:

Example; XYZ has 120m/= available for investment in the following projects at a cost of capital of 20%. Thereafter capital will be freely available.

Single period indivisible projects

In this case there is no systematic way of allocating capital. We have to use trial and error method to select a combination which gives the highest NPV subject to the capital constraint even if it means rejecting investments which appear higher in ranks.

IMPLICATIONS OF CAPITAL RATIONING

1. The best investment can be left out. For example investment A has the highest NPV but is left out because of insufficient fund.

2. You may lose competitive advantage in the market because of leaving out viable investments.

INCORPORATING RISK IN CAPITAL BUDGETING

In capital budgeting risk refers to possible variability between the estimated cash flows and the realized cash flows in implementing projects. The variability may be due to economic changes, changes in government policy, changes in social cultural value etc. when these variations occur then there is risk. Risk is associated especially with cash inflows because they go further into the future. Risk can be incorporated in capital budgeting by;

1. Measuring the extent of risk associated with the investment.

2. Adjust the expected cash inflows for risk.

 

MEASUREMENT OF RISK

Risk is generally an estimate and therefore involves subjectivity. Risk is determined by measures of Dispersion from the average cash flow of the investment. The investor has to establish the probability distribution of the cash flows so as to determine whether the cash flows are estimated by a normal distribution.