Money Market – Definition, Participants and its Types
Retail investors across the world do not have a high level of knowledge when it comes to money markets. This is because of the fact that money markets have been largely invisible to retail investors. For a significant amount of time, money markets have only been used by large corporations, banks, and other entities to […]
What is a Financial Market
A market is a place where two parties are involved in transaction of goods and services in exchange of money. The two parties involved are: Buyer Seller In a market the buyer and seller comes on a common platform, where buyer purchases goods and services from the seller in exchange of money. What is a […]
Stock Valuation – The Discounted Cash Flow Approach in Detail
In the past article we have seen how Discounted Cash Flow (DCF) is the most appropriate method of stock valuation because it is rational and objective. Now, it is time we have a look at the details of this model. Present Value of Expected Future Cash Flows The basic of this model seems to be […]
Types of Return Policies
As mentioned in previous articles, return policies can be very important from a consumer’s point of view. There have been several surveys conducted which show that most customers (especially online customers) do take return policies into account before they make a decision to shop with a particular retailer. Retailers which have stricter return policies have […]
How Securities are Priced in the Primary Market
We already know that primary financial markets are used by firms to raise funds from investors. This is done by issuing shares via an initial public offer, rights issue, or even using private placements. In each of these cases, the firm selling shares has to arrive at a market price at which they are willing […]
In the previous few articles we have come across different metrics that can be used to choose amongst competing projects. These metrics help the company identify the project that will add maximum value and helps make informed decisions to maximize the wealth of the firm.
We saw how the NPV rule was better than IRR and the profitability index and how decisions based on NPV are supposedly more accurate.
However, we need to understand that there is a difference between how the NPV rule is stated in text books and how it is applied in real life worldwide.
This difference arises because when we consider capital budgeting, we are working under the fundamental assumption that the firm has access to efficient markets. This means that if the required rate of return is greater than the opportunity cost of capital, or if the project has an NPV greater than zero, the firm can always finance its projects by raising money from the markets even if it doesn’t have any. Thus for practical purposes, the money at the firms disposal is unlimited.
However, in reality this may not be the case. True, that firms can always raise money and bigger firms can raise as much funds as they want to, but many times firms themselves place restrictions on the amount of fund raising that they undertake.
These restrictions could be placed because of the following reasons:
This restriction placed on the amount of capital that the company has, nullifies the assumption inherent in capital budgeting. Thus, what happens in real life is a slightly modified version of capital budgeting. Financial analysts have a name for this. They call it “Capital Rationing”.
So capital rationing is nothing but capital budgeting with modified rules. Now instead of choosing every project that has an NPV greater than zero, the firm uses a different approach.
All projects with a positive NPV qualify for a possible investment. These projects are then ranked according to their attractiveness. The firm then invests in the top3 or top 5 projects (based on their resources). So, here a finite amount of capital is being rationed amongst projects as opposed to an infinite capital assumption.
But, how does the firm decide which projects are the most attractive? Simply ranking the projects with higher NPV will be incorrect. This is because we are not paying attention to the input we are putting in.
We are simply paying attention to the output which is obviously incorrect. What if a project with a slightly higher NPV requires double the investment as compared to another project? Is it still a good bet?
Obviously not and to solve this problem and ration capital effectively, companies have come up with a metric called the Profitability Index. The profitability index is nothing but the NPV of the project divided by the amount of its investment.
Profitability Index = NPV/Investment
So we are simply looking at the NPV amount per dollar of investment. Projects with highest NPV per dollar of investment are considered more attractive and the investment dollars are first allocated to them so that the returns of the firm are maximized.
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