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Example the objective of capital rationing is to

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Unformatted text preview: r against total dollar investment. EXAMPLE The objective of capital rationing is to select the group of projects that provides the highest overall net present value and does not require more dollars than are budgeted. As a prerequisite to capital rationing, the best of any mutually exclusive projects must be chosen and placed in the group of independent projects. Two basic approaches to project selection under capital rationing are discussed here. Internal Rate of Return Approach The internal rate of return approach involves graphing project IRRs in descending order against the total dollar investment. This graph, which is discussed in more detail in Chapter 11, is called the investment opportunities schedule (IOS). By drawing the cost-of-capital line and then imposing a budget constraint, the financial manager can determine the group of acceptable projects. The problem with this technique is that it does not guarantee the maximum dollar return to the firm. It merely provides a satisfactory solution to capital-rationing problems. Tate Company, a fast-growing plastics company, is confronted with six projects competing for its fixed budget of $250,000. The initial investment and IRR for each project are as follows: Project Initial investment IRR A $ 80,000 B 70,000 20 16 12% C 100,000 D 40,000 8 E 60,000 15 F 110,000 11 The firm has a cost of capital of 10%. Figure 10.4 presents the IOS that results from ranking the six projects in descending order on the basis of their IRRs. According to the schedule, only projects B, C, and E should be accepted. Together they will absorb $230,000 of the $250,000 budget. Projects A and F are acceptable but cannot be chosen because of the budget constraint. Project D is not worthy of consideration; its IRR is less than the firm’s 10% cost of capital. The drawback of this approach is that there is no guarantee that the acceptance of projects B, C, and E will maximize total dollar returns and therefore owners’ wealth. net present value approach An approach to capital rationing that is based on the use of present values to determine the group of projects that will maximiz...
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