Lecture on Discounted Cash Flow: Further Aspects

Introduction

• Focus on Chapter 9: Discounted Cash Flow Further Aspects.
• Three Special Situations:
  1. Capital Rationing
  2. Replacement
  3. Lease vs. Buy
• Each has special techniques and separate lectures.

Capital Rationing

• Definition: Occurs when there is a limit on cash available for investment.
• Example Scenario:
  • Company has four projects (A, B, C, D) with given cash flows.
  • Each project has a calculated Net Present Value (NPV) at a 10% cost of capital.
  • Total capital needed for all projects exceeds available funds.

No Capital Rationing Scenario

• If no capital limits, the company should accept all projects with a positive NPV.
• Cash needed for all projects: $1,800.

Capital Rationing Scenario

• Available capital is only $1,600, hence not all projects can be funded.
• Objective: Maximize NPV with the limited available capital.

Infinitely Divisible Projects

• Projects can be accepted in any fraction (e.g., 50%, 10%), assuming proportional NPV returns.
• Cannot exceed 100% of a project.
• Calculation Approach:
  • Calculate NPV per dollar invested for each project.
  • Prioritize investments based on NPV per dollar.
• Order of Investment:
  1. Project D (highest NPV per dollar)
  2. Project C
  3. Project A
  4. Project B

Calculation Example

• Total NPV from best investment order: $174.
• NPV per dollar invested is referred to as the Profitability Index.

Projects Not Infinitely Divisible

• Projects must be accepted in whole (100%) or not at all.
• Possible Combinations:
  1. A, B, C
  2. A, C, D
  3. A, B, D
  4. B, C, D
• Choose combination with highest total NPV.
  • Best combination: A, B, D with total NPV of $157.

Unused Capital

• Surplus capital should not be borrowed unnecessarily.
• If not used, it should be returned or not borrowed at all.

Reasons for Capital Rationing

• Hard Capital Rationing: Lenders limit the maximum amount a company can borrow.
• Soft Capital Rationing: Company chooses to limit borrowing despite the ability to borrow more.
• Examples:
  • Hard: Lender-imposed borrowing limit.
  • Soft: Self-imposed borrowing limit by the company.

Conclusion

• The lecture primarily focused on capital rationing.
• Next lecture will cover the concept of replacement.