PROJECT SCREENING, PROJEC RANKING AND

CAPITAL RATIONING AND SENSITIVITY ANALYSIS

CAPITAL BUDGETING
CONCLUSION ON CAPITAL BUDGETING METHODS
Technique Unit of Suitable for Suitable for Useful for Useful for
Measurement non-normal choosing firms facing firms facing
cash flows between time capital
mutually constraints constraints
exclusive
projects
NPV Currency Yes Yes No Yes
Payback Time No No Yes No
Discounted Time No No Yes No
Payback
IRR Interest rate No No No Yes
Profitability Index Interest rate Yes No No Yes
Accounting rate Interest rate Yes No No Yes
of return
SELECTION PROBLEMS

 The three types of capital budgeting decisions are:

1. Accept-reject decisions
2. Mutually exclusive project decisions
3. Capital rationing decisions
ACCEPT-REJECT DECISION

 This occurs when an individual project is accepted or rejected without

regard to any other investment alternatives.
 Generally, as long as a firm has unlimited funds and only independent
projects, all projects meeting the minimum investment criteria should be
accepted.
 Independent projects are those for which the acceptance of one does not
automatically eliminate the others from further consideration.
 Using sophisticated capital budgeting techniques, such as NPV, PI and IRR,
to evaluate single, independent projects with conventional cash flow
patterns always leads to identical accept-reject decisions and the
maximization of shareholder wealth.
MUTUALLY EXCLUSIVE PROJECTS DECISION
 These are competing investment proposals that will perform the same
function or task. The acceptance of one or a combination of projects
eliminates the others from further consideration.
 The ranking of mutually exclusive projects may conflict based on accept-
reject decision rules. Among the major reasons for conflicting rankings
among mutually exclusive projects using sophisticated or advanced capital
budgeting techniques are:
1. Difference in expected economic lives of the projects;
2. Substantially difference in net investments (size) of the projects;
3. Difference in timings of cash flows; and
4. Difference in reinvestment rate assumptions in discounted cash flow
techniques.
MUTUALLY EXCLUSIVE PROJECTS DECISION

 When conflicting ranking occurs, the NPV is theoretically considered the

superior technique.The reasons are:
1. NPV method provides correct rankings of mutually exclusive investment
projects, whereas other DCF techniques sometimes do not.
2. NPV implicitly assumes that the operating cash flows generated by the
project are reinvested at the firm’s cost of capital which approximates the
opportunity cost for reinvestment. The IRR method assumes
reinvestment at the IRR which may not be a realistic rate. Also, IRR uses
different reinvestment rates for each competing alternatives.
3. NPV does not suffer from the weaknesses of either the IRR or
Profitability Index and leads to maximizing shareholder’s wealth.
CAPITAL RATIONING DECISION

 Optimal capital budget is the annual investment in long term assets that maximizes the
firm’s value. For planning purposes, manager must forecast the total capital budget,
because the amount of capital raised affects the Weighted Average Cost of Capital
(WACC) and thus influences project’s NET Present Values.
 It may be reasonable to assume that large, mature firms with good track records can
obtain financing for all its profitable projects. However, smaller firms, new firms and firms
with dubious track records may have difficulties raising capital even for projects that the
firm concludes would have highly positive NPVs. In such circumstances, the size of the
capital may be constraint, a situation called capital rationing.
 Capital rationing is a situation where a constraint or budget ceiling is places on the total
size of capital expenditures during a particular period.
CAPITAL RATIONING DECISION

 Capital rationing can also be described as the selection of the investment

proposals in a situation of constraint on availability of capital funds, to
maximize the wealth of the company by selecting those projects which
will maximize overall NPV of the concern
 In capital rationing situation, a company may have to forego some of the
projects whose IRR is above the overall cost of the firm due to ceiling on
budget allocation for the projects which are eligible for capital
investment.
 Capital rationing refers to a situation where a company cannot undertake
all positive NPV projects it has identified because of shortage of capital.
SENSITIVITY ANALYSIS

 One basic approach to evaluating cash flow and NPV estimates

involves asking “what if” questions. Sensitivity analysis is the
process of changing one or more variables to determine how
sensitive a project’s returns are to these changes. By asking
“what if” questions, the decision maker is able to identify
relevant variables affecting the final outcome. Once these
variables are identified, the decision maker can investigate the
variables more carefully in order to improve his/her ability to
predict them.
SENSITIVITY ANALYSIS

 The basic idea with a sensitivity analysis is to freeze all the

variables except one and then see how sensitive our estimate
of NPV is to changes in that one variable. If the NPV estimate
turns out to be very sensitive to relatively small changes in the
projected value of some component of project cash flow, then
the forecasting risk associated with that variable is high.
 Sensitivity analysis is useful for pointing out where forecasting
errors will do the most damage but does not tell us what to do
about possible errors.
REFERENCE:

Ma. Elenita Balatbat Cabrera (2012), Financial Management: Principles and Applications Comprehensive Volume 2012
– 2013 edition, GIC Enterprises & Co., Inc.