CAPITAL RATIONING

1
CAPITAL RATIONING

• There is hardly ever enough cash to invest in all
  investment opportunities
• Scarcity of resources makes one to use the
  limited resources in an optimal way
• Problem of rationing capital among competitive
  projects is called Capital Budgeting

2

• Project
• Acquire additional manufacturing facility
• Replace old grinding machine
• Produce parts for the assembly line

• Alternatives
• Lease an existing building
• Construct a new building
• Do manufacturing overseas
• 1. Purchase semiautomatic machine
• 2. Purchase automatic machine
• Make parts in the plant
• Buy parts from a subcontractor

3
Example 17.1

• Here are several proposals for a GM.
• The foundry wishes to purchase a new tool to
  speed up casting
• The machine shop asks for new inspection
  equipment
• Improvements must be made in the paint department
  to conform to the new air standards.
• Office manager needs a new safe.

4
Options for the GM

• A. Purchase the foundry equipmentB. Do nothing.
• A. get the inspection equipment.B. Do nothing.
• A. Buy Paint department equipmentB. Do nothing.
• A. Buy a new safe for the office.B. Do
  nothing.The GM can do any combinations. But do
  nothing is always an option.

5
Criteria for rejecting an alternative
6
Criteria for choosing the best alternative among
the ME alternatives
7
Rationing Capital by RORAvailable budget
650,000
8
Cutoff ROR

• MARR cutoff ROR opportunity cost
• Normally we use MARR to accept or reject
  projects. If the MARR used is not the cutoff ROR
  then we may be rejecting good projects or
  accepting bad projects.
• For this example cutoff rate is between 14 and
  15. We can take MARR 14.5 for future
  calculations.

9
Rationing capital by PW methods

• Lorie and Savage came out with the following
  suggestion
• Use a multiplier, p, to decrease the
  attractiveness of an alternative in proportion to
  its use of the scarce capital.
• Use NPW p(PW of costs)where, p is a
  multiplier.

10
Use of NPW p(PW of costs)

• Note that if p gt 0 and large then a project with
  NPW gt0 may have
• NPW p(PW of costs) lt 0 !!!!!
• By arbitrarily changing p until all attractive
  projects total cost equals the available capital
  is the method used for rationing the limited
  capital.
• Consider the previous example.

11
NPW 0.25(PW of cost)p values (.2 and .25),
MARR 8
12
At p 0.25 we have

• 1, 2, 4, 5, 6 and 9 are selected.
• This solution does not agree with the solution we
  found based on ROR selection.
• The reason for that is that the interest rate
  used in the table was MARR 8 but not the
  cutoff rate of 14.5 as we determined before.

13
For MARR 14.5
14
Ranking Project proposals

• The right method to rank projects is to rank the
  independent projects according to their value of
  net present worth divided by the net present
  cost. Use MARR as the appropriate interest rate
  which should be a reasonable estimate of the
  cutoff ROR.

15
Rationing Capital by Ranked NPW/PWCost method
16
Rank by NPW/PW of costs