Capital Rationing And Investment Evaluation: A Case Study

Case Study Scenario

Corporate Finance essentials help in understanding the key financial issues that is related with the companies, investors as well as interaction between them in the capital markets (White and Miles 2015). Evaluating the cash flow results is essential that focus mostly on how to understand the consequences of a trade case after investigating the monetary events resulting from a cash flow examination.

There are several investment opportunities that need to be evaluated in this case. There are mainly four financial metrics that are used by the decision makers at the time of reviewing the business case (Rossi 2015). Each of the investment opportunities are explained below with proper justification:

NPV is one of the capital budgeting techniques that are mostly used for analyzing a potential investment opportunity or in that cases a project (Rossi 2014). By using this method, cash flows are resultant from the trade case that is economical at a prospect cost of resources. Hence, the reduction rate would be the after-tax as well as weighted average cost of assets for a given corporation. Rule of NPV is to recognize all the scheme or savings where the NPV of cash flows is larger than 0 that means accepting positive NPVs (Mukherjee et al. 2013).

One of the benefits of NPV technique is that the technique used for evaluating the time value of money perception. This is when a dollar conventional nowadays is worth more than the dollar acknowledged a day from now (Mendes-Da-Silva and Saito 2014). Therefore, NPV is a measure that distinguish the risk in association with prospect cash flow as they are less positive

One of the disadvantages of NPV technique is that it is related to the simplicity measurement. According to the rule of NPV, decision maker are advisable to accept any project that is greater than zero but fails to specify when NPC can be achieved (Li 2015). Other restrictions of NPV approach is that the representation used assume resources to be abundant as there is no capital rationing. In case the capital is limited, the analyst looks for the size of investment first and then the NPV approach.

IRR is one of the capital budgeting techniques that are definite as the reduction rate where NPV of cash flows are equal to zero. Addition to that, IRR can be planned through examination error and iterative procedure (Kashyap 2014).  It is the forecaster who changes the discount rate until NPV arrives at zero.

Evaluating Investment Opportunities

Internal rate of return is one the essential financial measure at the time of evaluating the flows of money in a given project (Hise and Strawser 2013). The advantages of IRR are quite similar to that of NPV. The investment technique is based on discounted cash flows as well as distinguishes the time value for money. IRR should be used correctly as it calculate and provides outstanding leadership on a scheme price

One of the limitations of Internal Rate of Return is that it has multiple rate of return (Götze, Northcott and Schuster 2015). At the time of evaluating the scheme that has more than one modify in sign for the cash flow stream, then it is noted that the scheme may have numerous IRRs or no IRR at all. Other limitation of IRR is modify in reduction rates where the IRR rule tells that the forecaster recognize project of the IRR is better than the opening cost of assets or WACC. Therefore, if the discount rate transform every year, it is unfeasible to make this contrast. IRR do not add up in any case as the project is collective into one trade or evaluated on an incremental basis (Daunfeldt and Hartwi 2014).

Profitability Index is one of the benefit-cost ratios that are used for evaluating cash flows. Addition to that, profitability index rule tells supervisor as well as management for accepting all scheme that have an directory worth equivalent to or larger than 1 (Chua, Lowe and Puxty 2015).

One of the benefits of profitability index is that it offer the forecaster with the same consequence as the net present worth technique. If there is positive net cash flow, then profitability index will be greater than 1 (Chittenden and Derregia 2015).

Profitability index does not state when a optimistic cash flow is attain or providing an signal of the degree of cash flows as well as savings (Bierman and Smidt 2014).

Payback period is one of the capital budgeting technique that help in analyzing the trade case where the analyst view at how quickly a scheme returns the preliminary speculation back to the corporation (Ahmed 2013).

Payback period help executives as well as managers for evaluating the payback after recognizing the time value of money (Chittenden and Derregia 2015).

Payback period pay no attention to the entire cash flows that happen after the payback period is attaining.

Capital rationing is one of the techniques that are used for selecting a project that actually maximizes firm’s assessment when the capital combination is limited in nature (White and Miles 2015). There are two kind of capital rationing that include soft as well as hard capital rationing. It is the computation as well as technique used for prescribing the arranged projects in descending order based on profitability such as IRR, NPV and PI and decides on the best optimal arrangement.

NPV (Net Present Value)

It may happen in a situation when a company has to consider various profitable investment proposals. Most of the times there are resources limitations that are faced by companies (Bierman and Smidt 2014). This is due to investment policy made by business firm where they can acquire unlimited capital at one cost. It is the case when finance manager should be accepting the best combination of projects that totals up less than capital for achieving maximization of wealth. Hence, the process for evaluating as well as selecting of project is termed as capital rationing.

Capital rationing is a well-defined process that is used for distributing the available capital in and among the different speculation proposals in a manner where business achieves highest level for increasing the value (Chittenden and Derregia 2015). Based upon the foundation of constraint imposed on the resources, it is known that capital rationing is alienated into two sort such as hard capital rationing and soft capital rationing. Soft capital rationing takes place when the constraint is forced by the administration. On the other hand, hard capital rationing takes place when the resources combination is restricted by the peripheral users.

Capital rationing judgment- It is important to understand the fact that capital rationing decisions are used by managers for attaining optimum utilization of the available capital (Chittenden and Derregia 2015). Capital is always limited so it is not necessary to always accept the NPV that has positive cash flows. This is the reason why rational approach has to be taken into consideration as the best option for achieving or deciding over a particular project.

Capital rationing method- There is four major steps used at the time of conducting capital rationing method. The first step is to evaluate all the investment proposals that are mainly used under capital budgeting techniques such as NPV, IRR and PI (White and Miles 2015). The next step is to rank them on various criterions such as NPV, IRR and PI. The next step is to pick the plan in descending order of their productivity when the capital financial plan is exhausted after making use of capital budgeting technique. The last step is to compare the results of each of the above-mentioned method with admiration to total NPV as well as decide on the best from that (Chittenden and Derregia 2015).

 
Table: Calculation of NPV, IRR and PI

(Source: Created by Author)

IRR (Internal Rate of Return)

Graph: Calculation of NPV, IRR and PI

(Source: Created by Author)

The above table profiles the two substitute investments on the identical set of axes and use of illustration. The above table explains whether NPV and IRR reveal various preferences of the mutually exclusive projects. The differences can be understood on both scale problems as well as timing problem (White and Miles 2015).

All the measures that are mentioned in the table indicate project acceptability and these are as follows:

NPV>0

IRR>11%

PI>1.00

At 11% HT is favored over SQ as the profiles cross anywhere beyond 11% as well as before the purpose cross the necessary return axis when IRR of SW exceeds the IRR of HT. Addition to that, the performance can be elucidate by the fact that HT larger scale reason its NPV that exceeds that of SQ (White and Miles 2015). Hence, the smaller project as well as timing of SQ cash flows is more in the premature years that grounds its IRR for exceeding that has HT that has more of its cash flows in later years.

It is suggested to JK Products Inc for selecting the HT project as it has higher NPV and is the better system. Addition to that, PT is higher than that of Project SQ.

From the latest news release for the company JK Products Inc, it is mentioned that the company’s financial manager provides reasonable arguments for persuading the shareholders for improving over the investment pattern (Chittenden and Derregia 2015). As a financial manager, it is necessary for them to prefer an easily applied method that will consider cash flow as well as distinguish the time value of money. They should fully account for considering the predictable risk of return as and when functional to superior stock prices.

From the above calculation that was presented in the earlier part, it is easy to understand the scale problem as well as timing problem that clarify the potential effects on selection of the mutually exclusive projects through use of IRR versus NPV (White and Miles 2015). It can be noted that NPV can be used with mutually restricted projects after deducting the set of cash flows from the other as well as representing the differential cash flows. NPV, IRR and PI are related to one other as they gets adjusted for the time value of money as well as risk. At the same time, in case of a single scheme with conservative cash flows all the above-mentioned method will provide with the same accept or rejection decision by the financial manager. Selecting the plan with highest PI will not be the same as accepting a project with the highest NPV (Chittenden and Derregia 2015). It requires maximizing the shareholder wealth where managers need to add the most probable risk-adjusted or positive NPV dollars to the corporation. IRR as well as NPV are related to each other. In that, both the methods use time value of money as well as take risk into account. Addition to that, NPV financial records for danger through use of risk-adjusted reduction when IRR utilize a risk-adjusted scale that compares the project as well as making the accepting or rejecting the decision.

References

Ahmed, I.E., 2013. Factors determining the selection of capital budgeting techniques. Journal of Finance and Investment Analysis, 2(2), pp.77-88.

Bierman Jr, H. and Smidt, S., 2014. Advanced capital budgeting: Refinements in the economic analysis of investment projects. Routledge.

Chittenden, F. and Derregia, M., 2015. Uncertainty, irreversibility and the use of ‘rules of thumb’in capital budgeting. The British Accounting Review, 47(3), pp.225-236.

Chua, W.F., Lowe, T. and Puxty, T.., 2015. Critical perspectives in management control. Springer.

Daunfeldt, S.O. and Hartwig, F., 2014. What determines the use of capital budgeting methods? Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4), pp.101-112.

Götze, U., Northcott, D. and Schuster, P., 2015. Capital Budgeting and Investment Decisions. In Investment Appraisal (pp. 3-26). Springer Berlin Heidelberg.

Hise, R.T. and Strawser, R.H., 2013. Application of Capital Budgeting Techniques to Marketing Operations. Readings in Managerial Economics: Pergamon International Library of Science, Technology, Engineering and Social Studies, p.419.

Kashyap, A., 2014. Capital Allocating Decisions: Time Value of Money. Asian Journal of Management, 5(1), pp.106-110.

Li, X., 2015. Accounting conservatism and the cost of capital: An international analysis. Journal of Business Finance & Accounting, 42(5-6), pp.555-582.

Mendes-Da-Silva, W. and Saito, R., 2014. Stock exchange listing induces sophistication of capital budgeting. Revista de Administração de Empresas, 54(5), pp.560-574.

Mukherjee, T.K., Rahahleh, N.M.A., Baker, H.K. and English, P., 2013. Capital budgeting techniques in practice: US survey evidence. Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects, pp.151-171.

Rossi, M., 2014. Capital budgeting in Europe: confronting theory with practice. International Journal of Managerial and Financial Accounting, 6(4), pp.341-356.

Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), pp.43-56.

White, J.B. and Miles, M.P., 2015. A Proposed Capital Budgeting Technique For Liquidity Constrained Small Businesses. Journal of Small Business Strategy, 1(2), pp.36-46.

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