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Advanced (Practical) Issues in Capital

Budgeting (FM-II)
April 7, 2016

Dr. Triptendu Prakash Ghosh

Introduction 1

So far, we have analyzed only stand-alone projects (in FM-I)

Our job was simple
Estimate the cash flows from the investment, and
Discount the same at an appropriate discount rate

It was assumed that

selecting a good project has no effect on other concurrent or
subsequent projects
Firms with +ve NPV projects can raise capital at a fair price

A firm has required to choose between alternatives due to the

two following factors
Projects are mutually exclusive serving the same purpose
accepting one makes the other proposal redundant, and/or
Firm has limited capital it cannot take every project with
positive NPV/ high IRR
April 7, 2016

Introduction 2

But it is possible that making one investment decision may

force the firm to take another one in future (pre-requisite)
Current investment decision should take this into account

We also assumed that alternative proposals had same life

Though we mentioned a few dos & donts
We did not deal with the whole range of practical issues

We also talked about possible conflicts between NPV and

And the ways to resolve the conflict analytically

But we did not probe whether the choice of NPV versus IRR
(as decision rule/criterion) depends on
Firm characteristics, or
Project settings (e.g., size, life, risk, etc.)
April 7, 2016

Introduction 3

It is possible that project dependence (concurrent and

future/pre-requisite) may limit ability of managers to select
a current project
Its also possible that lack of capital may force managers to
reject other good (+ve NPV & high IRR) projects
Such, and other situations lead to Capital Rationing

April 7, 2016

Capital Rationing Defined

Capital Rationing (CR) occurs when

a firm is unable or unwilling to raise the capital and/or unable to
invest in projects that earn returns higher than the hurdle rate

CR may arise due to several factors (we discuss four major

1) Project Discovery: It is assumed that firms know when
they have good (+ve NPV / IRR>WACC) projects at hand
However, uncertainty and errors of project analysis may
lead to a firm feeling undecided about its own project
assessment (and the estimated +ve NPV)
And chose not to pursue the investment

April 7, 2016

Capital Rationing 1

2) Credibility: Theory says that a firm conveys information

about its projects to the funding entities (institutions or
Firms attempt to do so in practice as well
Because it is easy for a firm to claim that its future projects
are good, regardless whether such claims are actually true or
So funding entities require substantial backing for viability
of projects
Firms that are unable to provide this backing are unable to
convince funding entities
This is particularly serious for smaller firms and start-ups
April 7, 2016

Capital Rationing 2

That the projects will create value (on the top of the firms
own perceived indecisiveness about its own estimation of
3) Market Efficiency: Markets may remain (excessively)
optimistic (over-valued) or (extremely) pessimistic (undervalued) for a considerable period of time
That is, markets are not efficient since value is not equal
to price at all the times
Managers know the value better than anybody else
credibility of communication (or information asymmetry) is
another issue
When markets are undervalued (in times of recession, as in
2012/13 in India), stock prices continue to be depressed
April 7, 2016

Capital Rationing 3

Firms (naturally) tend not to issue fresh equity to finance

even the very best of the future projects
Since they will have to pay high price by selling equity at
lower than its value
See Example-1
The opposite happens when markets are overvalued
Leading to a tendency of over-investment
Because existing shareholders gain by issuing shares

That is a major cause of business cycles

April 7, 2016

Capital Rationing 4

4) Floatation Costs:
Direct (fees to investment bankers, bankers, legal experts, costs
of complaince, distribution costs, etc.) and
Indirect (under-pricing or selling at market price below true
value for IPOs & FPOs, negative announcement effect for FPOs)

Total costs may make funds prohibitively costly, reducing

NPV substantially
Implication of Capital Rationing
Firms cannot accept all +ve NPV projects because they
dont have unlimited capital
Projects have to be ranked and we are back into NPV
versus IRR issues
April 7, 2016

Fresh Look at NPV versus IRR under CR 1

We know that conflict may arise (between NPV rule & IRR
rule) in all situations except for
YES-NO decision (firm has only one investment opportunity),
Conventional project

We also know that the conflict occurs over a specific range

of values of the discount rate
Now we probe two further points of difference between
See Example 2A
Implicit assumption intermediate cash flows get
reinvested at hurdle rate (15%) for NPV and at IRR for
computation of IRR
April 7, 2016

Fresh Look at NPV versus IRR under CR 2

IRR (A: 33.66%, B: 20.88%) of both projects substantially

higher than cost of capital [COC] (15%)
Conflict arises in spite of the facts that
Both are conventional projects, and,
Since discount rates are same, ranking vis--vis Y/N decision is
not responsible for the conflict

The reason is difference in scale of projects

NPV is stated in rupee amount, and hence is affected by scale
IRR, being a rate, is not affected by scale

Thus, NPV tends to favor projects with larger scale, while

IRR is scale-independent

April 7, 2016

Fresh Look at NPV versus IRR under CR 3

There is a second (though less important) factor behind this

type of conflict (due to difference in scale of projects)
Both NPV and IRR (implicitly) assumes reinvestment of the
cash flows till the maturity
But NPV uses the (much-lower than IRR) COC as the discount rate
While IRR uses the IRR as the discount rate, which (i.e., the latter,
or the IRR) as the discount rate (COC of 15% for NPV, as against
IRR of 33.66% for A and 20.88% for B)

While a smaller rate (of COC than IRR in either case) at the
denominator makes NPV larger, the IRR is not dependent on
the COC
The result is: while NPV tends to favour larger projects, IRR is
invariant to scale and COC
So long as both have positive NPV and IRR>COC(of A &/or B)
April 7, 2016

Fresh Look at NPV versus IRR under CR 4

Apart from scale (& difference in implicit discount rates),

different timing of cash flows is also a culprit
Demonstrated by the case of comparing NPV for two projects
with similar scale Example 2B

NPV-IRR conflict still arises for RANKING



Due to difference in (implicitly assumed) reinvestment rates

(COC for NPV and IRR for IRR Rule)
And when larger portion of CF coming in later years (Project B
of Ex-2B) nullifying the effect of reinvestment assumption

Timing of cash flows may also be responsible for the NPVIRR conflict
It appears from Ex-2A that IRR does a better job in taking
into account the timing of cash flows
April 7, 2016

Fresh Look at NPV versus IRR under CR 4

Consequences are that the NPV Rule

Is biased towards investments of larger scale
Is biased towards projects for which a larger proportion of CFs
come at later stage than otherwise
Due to lower discount rate

Does not lead to best use of capital in the presence of capital

rationing (limited capital)

In general, IRR rule is generally better for capital-rationed

But its reinvestment assumptions may still skew the investment
For example, in those genuine cases where external conditions
dictate that the scale of the project is high and/or CFs can only
come at later stage

How do we relate the above to Capital Rationing?

April 7, 2016

Fresh Look at NPV versus IRR under CR 5

This is how:
If the firm has easy access to capital markets, and/or if the
extent of information asymmetry faced by the firm is low,
Leading to the difference in cost of external and internal finance
It can select both projects
Since both yield positive NPV as well as high IRR (above cost
of capital even beyond WACC of 19.35%)

If the firm faces Capital Rationing,

Due to substantial information asymmetry
Causing the cost of external finance to be substantially higher
than internal finance
Choosing the project requiring larger investment (B) may force it
to abandon future projects even with higher NPV and/or IRR
than projects A & B now
April 7, 2016

Fresh Look at NPV versus IRR under CR 6

Thus, if the objective is to maximize shareholder value

creation under limited capital (Capital Rationing)
The smaller scale project (A) (of Ex-2A) is a better choice
Since it uses a much smaller capital

Hence we conclude that firms facing substantial information

asymmetry, like those who
Are small in size
Lack physical assets to collateralize
Face riskier operating environment, and so on

Should rather follow IRR as the decision rule, in stead of

Thus firms facing lower degree of information asymmetry
(e.g., large and long-listed firms) will do better by following
the NPV rule
April 7, 2016

Fresh Look at NPV versus IRR under CR 7

There are three modifications to traditional rules (leading to

NPV-IRR conflict due to any of the factors) yielding better
A) Using a scaled version of NPV called Profitability Index (PI)
B) Using a Modified IRR (MIRR) approach with more
reasonable reinvestment rate assumptions
C) Using a more complex linear programming approach that
allows capital constraints across many periods (& not just for the
current period)

The above may be viewed as three alternate attempts to save

NPV (from the IRR attack)

April 7, 2016

Fresh Look at NPV versus IRR under CR 8

A) PI: First Attempt to Save the NPV Rule

This one tries to address the weakness of NPV Rule arising
due to scale effect
PI = NPV / (Initial Investment)
PI for a project measures the total value creation to a firm
per rupee of initial investment (if project accepted)
When there is Capital Rationing and there are several
positive NPV projects,
Rank the projects in descending order of PI, and
Select the projects from the top that is allowed by available

April 7, 2016

Fresh Look at NPV versus IRR under CR 9

Note: Another version defines the PI ratio as PV of all CFinflows to PV of all CF-outflows during the life of the
The resulting ranking will be the same by PI as defined before

See Example 3A
There are several limitations of the PI-based Ranking
A.i) It concentrates on the current period only but capital
rationing constraint is usually spread over more than one
Projects chosen this year (using PI) may limit the firms ability
to investment in more profitable future projects

A.ii) PI fails to ensure that projects chosen this year will

absorb investable funds available this year
April 7, 2016

Fresh Look at NPV versus IRR under CR 10

See the choice of projects in Ex-3A with a constraint of Rs. 100
crore, and note the amount that cannot be invested
Now assume that Project B (in Example-3A) is a necessary prerequisite for any of the other projects, and find out resources that
cannot be invested due to capital constraint of current year
Compare the two outcomes
See Ex-3B

B) MIRR: Second Attempt to Save NPV

Here a reconciliation between NPV and IRR is attempted
One reason of conflict is the different re-investment rate
assumption (IRR at IRR but cost of capital for NPV)
Modified IRR (MIRR) is the IRR for which reinvestment of
intermediate cash flows is done at cost of capital
April 7, 2016

Fresh Look at NPV versus IRR under CR 11

At cost of equity if cash flows are to equity investors, and
At cost of capital if cash flows are to the firm

See Example-4
Many believe that MIRR is a mix of the NPV and IRR rules
Not without reason

In practice, MIRR is a weighted average of returns on

individual projects (IRR) and hurdle rates (CoC) used by the
With weights on each depending on magnitude and timing of cash
Larger and earlier the cash flows from the project, greater is the
weight attached to the CoC (Cost of Capital)

MIRR leads to removal of NPV-IRR conflict for projects of

same scale and lives
April 7, 2016

Fresh Look at NPV versus IRR under CR 12

C) Multi-period Capital Rationing the Third Attempt

So far we focused on current period capital rationing
In reality, it applied across time periods
When multi-period constraints are combined with projects
that require investment over many periods,
Our existing toolkit fails to handle the complexity
The solution is to apply linear programming
Problem formulation is as follows:

April 7, 2016

Fresh Look at NPV versus IRR under CR 13

The objective function is:


j 1


Where Xj=1 if Investment j is taken; 0 otherwise

Subject to the constraints:

j 1

INV j ,1 1,000

j 1

j 1

April 7, 2016

INV j , 2 1,200

INV j ,3 1,400

INVj,t = Investments (in

Rs. Million) required on
investment j in period t.

Further Issues in Capital Budgeting 1

Raising Hurdle rates to Handle Capital Ratoning

Many firms, when faced with CR, simply raise the hurdle
So that fewer projects are available on the drawing board
There are several problems with this approach
Once adjusted, firms may fail to correct it, especially when the
constraint gets relaxed with increase in size and age of firm
NPV computed by using a discount rate that is higher than the
true discount rate does not convey the same information
amount of wealth increase
Finally, this penalizes all projects whether capital-intensive or
Even PI does a better job in conserving scarce capital
April 7, 2016

Further Issues in Capital Budgeting 2

Project Dependence
Even in the absence of CR, selection of one project may
lead to rejection of another
For example, an information technology product to do a
particular job, or product distribution service

See Examlpe-5.
Problem arises when two mutually exclusive projects have
unequal lives
Projects with Unequal Lives
Consider a 5-year and a 10-year project
The 5-year project may be replicated for another 5 years
And now the 10-year project can be compared with
replicated two 5-year projects
April 7, 2016

Further Issues in Capital Budgeting 3

Now consider a 5-year and a 4-year project

To compare the two, we must relpicate 5-year project 4
times and 4-year project 5 times
And then compare two 20-year projects

What if you have to compare 6-year, 7-year and 9-year

after replication, you face the daunting task of estimating
cash flows for 126 years !!!
There is a better method

April 7, 2016

Further Issues in Capital Budgeting 4

Equivalent Annuities Method

It is the annualized NPV of a multi-period project
Since it is a figure on per annum basis, projects with
unequal lives can be compared
The formula is as follows:

Equivalent _ Annuity NPV *
1 1 r

r: project discount rate
n: project lifetime

See Example-6.
April 7, 2016

Real Options in Capital Budgeting

Traditional capital budgeting fails to take into account the

myriads of options
That are involved in actual capital budgeting decisions

There are three major types in capital budgeting

Option to delay a project
Option to expand to cover new product and/or market in future
Option to abandon

What are options? What are financial options? What are real
options? How are they (financial and real options) different?

April 7, 2016


AD6 & RWJK8 (see course outline for detailed reference)

April 7, 2016