NAKURU TOWN CAMPUS COLLEGE

UNIT CODE: BFIN 332.

UNIT TITTLE: ADVANCED FINANCIAL MANAGEMENT ONE.

LECTURERS NAME: PROF K.A BASWETI.

STUDENTS NAME: OGUTU OKOTH KYRILLOS

STUDENT NUMBER: C12/03003/20

ASSIGNMENT ONE
 ADVANCED ASPECTS OF CAPITAL BUDGETING

Capital rationing

Capital rationing refers to a situation where the firm is constrained for external or self-imposed,
reasons to obtain necessary funds to invest in all investment projects with positive NPV. Under
capital rationing, the management not only has to simply determine the profitable investment
opportunities, but it has also to decide to obtain that combination of the profitable projects which
yields highest NPV within the available funds.

Capital rationing can also be referred to as the process through which companies decide how to
allocate their capital among different projects, given that their resources are not limitless. The main
goal is to maximize the return on their investment.

Capital rationing is a process that companies use to decide which investment opportunities
make the most sense for them to pursue.

The typical goal of capital rationing is to direct a company's limited capital resources to the projects
that are likely to be the most profitable.

Hard capital rationing refers to restraints put on a company by outside entities, such as banks or
other lenders.

Soft capital rationing results from a company's own policies relating to how it wants to use its
capital.

Understanding Capital Rationing

Businesses typically face many different investment opportunities but lack the resources to pursue
them all. Capital rationing is a way of allocating their available funds in a logical manner.

A company will typically attempt to devote its resources to the combination of projects that offers
the highest total net present value (NPV).

Companies may also use capital rationing strategically, forgoing immediate profit to invest in
projects that hold out greater long-term potential for the business as it positions itself for the future.
Capital rationing may arise due to external factors or

internal constraints imposed by the management. Thus

there are two types of capital rationing:

1. External capital rationing

2 Internal capital rationing.

External Capital Rationing

External capital rationing mainly occurs on account of the imperfections in capital markets.
Imperfections may be caused by deficiencies in market information or by rigidities of attitude that
hamper the free flow of capital. For example, Supreme Electronics Ltd is a closely held company. It
borrows from the financial institutions as much as it can. It still has investment opportunities, which
can be financed by issuing equity capital. But it doesn’t issue shares. The owner-managers do not
approve the idea of the public issue of shares because of the fear of losing control of the business.
Consider another case. Tan India Wattle Extracts Ltd.

Internal Capital Rationing

Internal capital rationing is caused by self-imposed restrictions by the management. Various types of
constraints may be imposed. For example, it may be decided not to obtain additional funds by
incurring debt. This may be a part of the firm’s conservative financial policy. Management may fix an
arbitrary limit to the amount of funds to be invested by the divisional managers. Sometimes
management may resort to capital rationing by requiring a minimum rate of return higher than the
cost of capital. Whatever may be the type of restrictions, the implication is that some of the
profitable projects will have to be foregone because of the lack of funds. However, the NPV rule will
work since shareholders can borrow or lend in the capital markets. It is quite difficult sometimes to
justify the internal capital rationing. But generally, it is used as a means of financial control. In a
divisional set-up, the divisional managers may overstate their investment requirements. One way of
forcing them to carefully assess their investment opportunities and set priorities is to put upper
limits to their capital expenditures. Similarly, a company may put investment limits if it finds itself
incapable of coping with the strains and organizational problems of a fast growth.

Examples of Capital Rationing

Suppose that based on its borrowing costs and other factors, ABC Corp. has set 10% as the minimum
rate of return it wants from its capital investments. This is sometimes referred to as a hurdle rate. As
ABC weighs its various investment opportunities it will look at both their likely return and the
amount of capital they require, ranking them according to what's known as a profitability index.

For example, if one project is expected to return 17% and another 15%, ABC may fund the 17%
project first and fund the 15% one only to the extent that it has capital left over. If it still has capital
available, it might then consider projects returning 14% or 13% until its capital has been fully
allocated. It would be unlikely to fund a project returning below its hurdle rate unless it has other
reasons for doing so, such as to comply with government requirements. A company might also
choose to hold onto its capital if can't find enough attractive investment opportunities or if it
foresees difficult times ahead and wants to keep funds in reserve.

The cost of borrowing is often expressed in terms of an effective annual interest rate, which takes
into account both the simple interest rate that a lender charges and the effect of compounding. A
company's cost of borrowing is based in part on its likelihood of defaulting on the debt.

Businesses can raise capital in several ways. They can borrow money through loans or by issuing
bonds, known as debt capital. They can also raise equity capital by selling shares in the business. And
they can generate their own capital in the form of retained earnings, which represents income they
still have left over after meeting their other obligations, such as stockholder dividends.

Working capital is a measure of a company's current assets minus its liabilities. Working capital is
used to meet the company's short-term financial obligations.

The bottom line is that companies are limited in how much capital they have available to invest in
new projects at any given time. Capital rationing is a way for them to decide how to allocate their
capital among those projects. The goal is typically to maximize the return on their investment,
although long-term strategy and other factors can also come into play.
To use profitability index in capital rationing under capital rationing, we need a method of selecting
that portfolio of projects which yields highest possible NPV within the available funds

Replacement of projects in capital budgeting

To replace projects in capital budgeting, we use the replacement chain method, a method of capital
budgeting decision model that compares two or more mutually exclusive capital proposals with
unequal lives. The replacement chain method takes into consideration the different life spans of
alternative plans, as well as their expected cash flows. That makes it easier to compare the
proposals.

In replacement chain analysis, the net present value (NPV) is determined for each plan. One or more
iterations (the "links" in the replacement chain) can be completed to create comparable timeframes
for the projects. By comparing the proposals over like periods of time, accept-reject information for
the various projects becomes more reliable.

The methodology involves determining the number of years of cash flow (the project lives) for each
of the projects and creating "replacement chains," or iterations, to fill in the blanks in the shorter-
lived project. Suppose that project A has a five-year life span, while project B has a ten-year life span.
Project A's data can be projected to the next five-year period to match project B's ten-year life span.
Of course, any net investments and net cash flows for each iteration are also taken into
consideration. The NPV of each project can then be calculated to provide reliable accept-reject
information. The NPV is the present value of the net cash flow stream resulting from a project,
discounted at the firm's cost of capital, less the project's net investment.

Examples of types of projects where replacement chain method analysis can be useful include a
transportation company weighing whether to upgrade its fleet. Another case where it might be used
is in helping a mining company to evaluate which plant development project to pursue.

Alternatives to the Replacement Chain Method

The replacement chain method is not the only way to evaluate mutually exclusive projects with
unequal lives. The equivalent annual annuity method (EAA) is an alternative method. The EAA's
approach is to assess each project based on its projected annuity stream (series of equal payments).
That is done by first calculating the NPVs of each project, then converting each into an equivalent
annuity. Using this approach, the project with the highest EAA is considered more desirable.

Which method is better for making capital investment decisions? Since both the replacement chain
and the EEA models rely on NPV versus internal rates of return (IRR) calculations, they should reach
the same conclusions. It is only the approaches that differ.

Unequal live projects using least common multiple [LCM]

LCM is a method to evaluate capital projects that are mutually exclusive and that have unequal lives.
In the existence of two mutually exclusive projects, it means that the company can only chose one of
the two projects. Incase both projects have different lives, it is impossible to compare them directly
instead make an adjustment first. In particular, what we do is creation of a so-called replacement
chain. It means that we repeat the investment of the project with the shortest life span a number of
times until it matches the lifespan of the project with the longer lie span.

We consider the following example to make things clearer. Let’s assume we have two projects. The
first project has a useful life of 6 years, the second project only has a useful life of only 3 years. Thus,
we are dealing with projects with unequal lives.

The solution to the problem is to extend the project with a lifespan of only three years. In particular,
after three years we repeat the investment under the second project a second time. That way, both
projects have a useful life of 6 years and we can compare the NPVs. The following table implements
an example.

Inflation and advanced aspects of capital budgeting

Inflation is an ever-persistent condition in today’s economy. The purchasing power of money has
been reducing year after year for decades now. Apart from the occasional recession where money
may gain real value, the usual case is a loss of value. Investors are investing money today. They want
to be compensated for the inflation and still get a return over and above it. This simply means that
they want to gain value in real terms.

It is important for us to understand this while coming up with our cash flow estimations. This is
because projects never give all of their cash flows in the same period. Cash flows from projects are
usually spread out over many years, even decades. The treatment of inflation therefore becomes
very important to come up with the correct value. Minor changes in the assumptions about inflation
are capable of producing massive changes in the expected return from the project. A viable project
may become unviable simply by tweaking the inflation numbers a little bit. This article will explain
how inflation needs to be treated while performing these calculations:
How inflation affects different components of the economy

First, we need to understand that inflation never affects all the components of the income
statement uniformly. Therefore, assuming a uniform rate for all the components might give
theoretically correct answers, but in practical life it will be a blunder. For instance, consider the fact
that labor costs will go up every year. Employees usually expect to be paid a hike every year. Also,
the cost of raw materials is expected to go up every year. Tax rates change every year. However, the
increase in sales price cannot match these changes. It will usually be either more or less than the
percentage change in other components. Sales price is market driven and we can’t just raise it
without incurring any loss.

The bottom line therefore is that a good analyst will study the past record of each of these
components in terms of their inflationary tendency. He/she will then try to make forecasts about the
future trends that are likely to prevail. Based on this, every component should have its own unique
rate of inflation. In more detailed analyses, inflation forecasts will vary year to year depending on
how the analyst predicts the economy to behave.

Inflation has ramifications for the realized value of a capital project.

When evaluating capital projects, companies can evaluate capital projects in nominal or real (i.e.,
inflation adjusted) terms.

Real cash flows are based on purchasing power at the time the decision to invest would is made.

Under a real cash flow approach, the discount rate would remove the expected inflation rate, as the
cash flows will already reflect the effects of inflation.

Commonly, capital projects are analyzed in nominal terms, so the discount rate applied is inclusive of
expected inflation; however actual inflation may veer from expectations and inflation may impact
the different project variables in different ways.

There are several aspects of inflation that an analyst must consider when evaluating a capital
project:

Inflation and the Depreciation Tax Shied: if inflation is higher than expected at the time of the
investment decision, then the value of the depreciation tax shield is lowered and true net present
value of the project is lowered.

Inflation and Debt Payments: the discount rate may be based on a company’s cost of debt, if debt is
used to finance the capital project. When inflation is lower than expected, this increases the firm’s
debt costs and lowers the net present value of the project.

Inflation, Revenues, and Expenses: the revenues and expenses associated with a capital project will
not be equally affected by inflation. When a firm is not able to pass the costs of inflation to product
inputs on to customers in the form of higher prices, the net present value of the project will be lower

International capital budgeting

One of the most vital decisions firms make is the capital investment decision—selecting value-
creating investment projects that will increase the current market value of the firm. As the firm
expands the geographical scope of its activities, it will consider entering foreign markets, retooling
foreign assembly operations, offshoring, or even acquiring foreign businesses. The primary
motivation for these important decisions is undoubtedly strategic, but ultimately each “go” decision
will have to be validated by a feasibility study that includes traditional financial analysis. This is a
complex exercise fraught with many more unknowns. This chapter develops a framework for directly
comparing contending foreign investment proposals in a way that systematically incorporates the
many complicating factors that uniquely shape each project under review.

It concentrates on;

 The foreign direct investment process within which capital budgeting is embedded.
 The differences between valuing international projects and valuing domestic ventures.
 How to identify relevant cash flows for an international project.
 Why it is crucial to value the project in the host country's local currency terms first and then
in the investor's reference currency.

How to identify relevant cash flows for an international project

A definition often used for relevant cash flows states that they must be cash flows that occur in the
future and are incremental.

Cash flow

While on the face of it obvious, only costs or revenues that give rise to a cash flow should be
included. Accordingly, for example, depreciation charges should be excluded.

Future

Any relevant cash flow should arise in the future. Anything that has occurred in the past is referred
to as a sunk cost and should be excluded from relevant cash flows.

Incremental

Only cash flows that arise because of the decision being made should be included; any cash flow that
would have arisen anyway, sometimes referred to as a committed cost, should be excluded.

Opportunity cost

While not specifically included in the definition of a relevant cash flow (as noted above) opportunity
costs are also relevant cash flows. Opportunity costs are the revenues that are lost (or additional
costs that arise) from moving existing resources from their current use and are therefore considered
to be incremental cash flows arising in the future to be taken into account. These definitions sound
easy, and candidates often do well when relevant cash flows are examined in a written format.
However, it is applying these concepts to a scenario and calculating/identifying the relevant cash
flows that can often cause candidates problems, and it is this that I shall now focus on using excerpts
from the question in Appendix 1 as examples where possible. Please read the question before
continuing.

A numerical example is shown in the example bellow

In the context of whether a business owner will move her business, we are told that ‘Mrs. Clip
currently advertises her business in the local newspapers and business directories, at a cost of
$1,000 per year payable in advance. Mrs. Clip will carry on with this advertising…’.

Relevant cash flows are as follows

On a relevant cash flow basis, we do not need to be concerned with what has been paid in the past,
so the $1,000 per year paid in the past is a sunk cost and can be ignored from relevant cash flows.

What about the $1,000 per year in the future if Mrs. Clip continues with the advertising? This would
not be included as a relevant cash flow, because it is not incremental. The $1,000 cash flow is being
suffered now and will continue in the future, whether or not Mrs. Clip moves her business to the
town center premises. The cash flow does not arise because of the decision being made; it arises
anyway and is therefore not a relevant cash flow.
 COST OF CAPITAL STRUCTURES

Cost of capital is a company's calculation of the minimum return that would be necessary in order to
justify undertaking a capital budgeting project, such as building a new factory. The term cost of
capital is used by analysts and investors, but it is always an evaluation of whether a projected
decision can be justified by its cost. Investors may also use the term to refer to an evaluation of an
investment's potential return in relation to its cost and its risks.

Many companies use a combination of debt and equity to finance business expansion. For such
companies, the overall cost of capital is derived from the weighted average cost of all capital
sources. This is known as the weighted average cost of capital (WACC).

Cost of capital represents the return a company needs to achieve in order to justify the cost of a
capital project, such as purchasing new equipment or constructing a new building. Cost of capital
encompasses the cost of both equity and debt, weighted according to the company's preferred or
existing capital structure. This is known as the weighted average cost of capital (WACC).

A company's investment decisions for new projects should always generate a return that exceeds
the firm's cost of the capital used to finance the project. Otherwise, the project will not generate a
return for investors.

The concept of the cost of capital is key information used to determine a project's hurdle rate. A
company embarking on a major project must know how much money the project will have to
generate in order to offset the cost of undertaking it and then continue to generate profits for the
company. Cost of capital, from the perspective of an investor, is an assessment of the return that
can be expected from the acquisition of stock shares or any other investment. This is an estimate
and might include best- and worst-case scenarios. An investor might look at the volatility (beta) of a
company's financial results to determine whether a stock's cost is justified by its potential return.

Weighted Average Cost of Capital (WACC)

A firm's cost of capital is typically calculated using the weighted average cost of capital formula that
considers the cost of both debt and equity capital.Each category of the firm's capital is weighted
proportionately to arrive at a blended rate, and the formula considers every type of debt and equity
on the company's balance sheet, including common and preferred stock, bonds, and other forms of
debt.

Finding the Cost of Debt

The cost of capital becomes a factor in deciding which financing track to follow: debt, equity, or a
combination of the two. Early-stage companies rarely have sizable assets to pledge as collateral for
loans, so equity financing becomes the default mode of funding. Less-established companies with
limited operating histories will pay a higher cost for capital than older companies with solid track
records since lenders and investors will demand a higher risk premium for the former. The cost of
debt is merely the interest rate paid by the company on its debt. However, since interest expense is
tax-deductible, the debt is calculated on an after-tax basis as follows:

Cost of debt=

Total debt

Interest expense

×(1−T)

where:

Interest expense=Int. paid on the firm’s current debt

T=The company’s marginal tax rate

Finding the Cost of Equity

The cost of equity is more complicated since the rate of return demanded by equity investors is not
as clearly defined as it is by lenders. The cost of equity is approximated by the capital asset pricing
model.

CAPM(Cost of equity)=Rf +β(Rm−Rf)

where:

Rf =risk-free rate of return

Rm =market rate of return

Beta is used in the CAPM formula to estimate risk, and the formula would require a public
company's own stock beta. For private companies, a beta is estimated based on the average beta
among a group of similar public companies. Analysts may refine this beta by calculating it on an
after-tax basis. The assumption is that a private firm's beta will become the same as the industry
average beta. The firm’s overall cost of capital is based on the weighted average of these costs.

For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt;
its cost of equity is 10% and the after-tax cost of debt is 7%. Therefore, its WACC would be:

(0.7 \times 10\%) + (0.3 \times 7\%) = 9.1\% (0.7×10%) +(0.3×7%) =9.1%
This is the cost of capital that would be used to discount future cash flows from potential projects
and other opportunities to estimate their net present value (NPV) and ability to generate value.
Companies strive to attain the optimal financing mix based on the cost of capital for various funding
sources. Debt financing is more tax-efficient than equity financing since interest expenses are tax-

deductible and dividends on common shares are paid with after-tax dollars. However, too much debt
can result in dangerously high leverage levels, forcing the company to pay higher interest rates to
offset the higher default risk

Cost of Capital vs. Discount Rate

The cost of capital and discount rate are somewhat similar and the terms are often used
interchangeably. Cost of capital is often calculated by a company's finance department and used by
management to set a discount rate (or hurdle rate) that must be beaten to justify an investment.
That said, a company's management should challenge its internally generated cost of capital
numbers, as they may be so conservative as to deter investment.

Cost of capital may also differ based on the type of project or initiative; a highly innovative but risky
initiative should carry a higher cost of capital than a project to update essential equipment or
software with proven performance.

Importance of Cost of Capital

Businesses and financial analysts use the cost of capital to determine if funds are being invested
effectively. If the return on an investment is greater than the cost of capital, that investment will end
up being a net benefit to the company's balance sheets. Conversely, an investment whose returns
are equal to or lower than the cost of capital indicate that the money is not being spent wisely.

The cost of capital can also determine a company's valuation. Since a company with a high cost of
capital can expect lower proceeds in the long run, investors are likely to see less value in owning a
share of that company's equity.

Real-World Examples

Every industry has its own prevailing average cost of capital.

The numbers vary widely. Homebuilding has a relatively high cost of capital, at 6.35, according to a
compilation from New York University's Stern School of Business. The retail grocery business is
relatively low, at 1.98%.

1. The cost of capital is also high among both biotech and pharmaceutical drug companies,
steel manufacturers, internet software companies, and integrated oil and gas companies.
2. Those industries tend to require significant capital investment in research, development,
equipment, and factories.
3. Among the industries with lower capital costs are money center banks, power companies,
real estate investment trusts (REITs), and utilities (both general and water).

Such companies may require less equipment or may benefit from very steady cash flows.
 Importance of cost of capital

Most businesses strive to grow and expand. There may be many options: expand a factory, buy out a
rival, build a new, bigger factory. Before the company decides on any of these options, it determines
the cost of capital for each proposed project. This indicates how long it will take for the project to
repay what it cost, and how much it will return in the future. Such projections are always estimates,
of course. But the company must follow a reasonable methodology to choose between its options.

Difference Between the Cost of Capital and the Discount Rate

The two terms are often used interchangeably, but there is a difference. In business, cost of capital is
generally determined by the accounting department. It is a relatively straightforward calculation of
the breakeven point for the project. The management team uses that calculation to determine the
discount rate, or hurdle rate, of the project. That is, they decide whether the project can deliver
enough of a return to not only repay its costs but reward the company's shareholders.

Calculation of the Weighted Average Cost of Capital

The weighted average cost of capital represents the average cost of the company's capital, weighted
according to the type of capital and its share on the company balance sheet. This is determined by
multiplying the cost of each type of capital by the percentage of that type of capital on the
company's balance sheet and adding the products together.

In conclusion, the cost of capital measures the cost that a business incurs to finance its operations. It
measures the cost of borrowing money from creditors, or raising it from investors through equity
financing, compared to the expected returns on an investment. This metric is important in
determining if capital is being deployed effectively.
 THE UTILITY THEORY

In the field of economics, utility (u) is a measure of how much benefit consumers derive from certain
goods or services. From a finance standpoint, it refers to how much benefit investors obtain from
portfolio performance. While it may be intuitive to assume that all investors would like to achieve
very high returns, it is important to realize that such returns typically require the investor to take on
a lot of risks. Risk and return are trade-offs and follow a linear relationship. High-risk investments
present a high.

Measurement of utility

Since the u scale varies greatly between individuals, and as individuals have different u functions, it is
quite difficult to quantify u. However, it is sometimes possible to use dollars as a quantitative
measure of u.

Consider the following example: Ben is considering buying a new house. After conducting extensive
research, Ben has narrowed down his options to the following:

From a value standpoint, Home B is a better deal since it provides more benefit as a standalone
entity. However, Ben works downtown and thus decides to pay $2 million for Home A instead. In
such a case, we can say that Ben’s utility of living downtown is $1.5 million (the premium over Home
B). In certain cities, there may be many people like Ben that would pay a large premium to live in a
certain area. In such cases, studies can be conducted to further understand consumer behavior and
draw additional insights.

Marginal utility refers to how much incremental utility an individual derives from obtaining one
additional unit of a certain good or service. Consumers derive decreasing marginal u from goods and
services available in an economy. This means that after having a certain amount of a particular good
or service, the u of acquiring one more unit of the good/service falls.
A recent study has found that people earning $95,000 per year derive just as much u from their
salary as people earning $200,000 per year. This illustrates the concept of decreasing marginal u;
after $95,000, individuals begin to value other things (such as time) much more than money.

Types of Utility Curves

Generally speaking, there are three types of utility curves that explain the relationship investors
have with risk.

Type I – Risk Averse

This type of utility trend is what most individuals experience, according to the study cited above.
From a conceptual standpoint, graphing this type of utility would give us the following.

As the investor takes on more risk (and thus the possibility of greater returns), they will start to have
a smaller and smaller desire to take on further risk.

Type II – Risk Neutral

This attitude towards risk would be perfectly linear and not face changes in marginal utility. The
graph below illustrates this relationship.
In practice, such an investor would continuously take on more risk since this will result in more
utility. This type of investing behavior is quite rare.

Type III – Risk Loving

This attitude towards risk would be exponential, meaning that this investor experiences increasing
marginal utility. The graph below illustrates this relationship: