What is Cost of Equity? – Meaning, Concept and Formula
February 12, 2025
The creation of a financial model is like a project which has to be undertaken by the company. This means that just like any other project, testing the functioning of the financial model should ideally be included in the project. However, in most cases, testing the financial model is generally the last phase of the […]
Legal costs have long been a deterrent for people wanting to file lawsuits. In a country like America, the legal fees can be significant. A lot of good lawyers charge hourly fees. Many plaintiffs believe that in an hourly fee system, the lawyer is incentivized to drag the case for as long as possible. This […]
Wall Street is very sensitive to communication. Every quarter, executives from top companies communicate their results to the street. Based on the content of this communication, the market reacts. Sometimes the market turns volatile. However, at other times the market remains stable. Apart from the content being communicated, the manner in which it is also […]
The banking system is the bedrock upon which the modern financial system stands. The banking system is highly integrated with the entire economy. Retail borrowers, small and medium enterprises, large companies as well as governments are all involved in borrowing money from banks at regular intervals. It is for this reason that the well-being of […]
What is the Fed Wire System? The Fed Wire system is a service that is offered by the Federal Reserve, which is the central bank of the United States. This service is provided by the main Federal Reserve bank as well as its twelve regional offices. Since this service is offered by the central banking […]
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.
Your email address will not be published. Required fields are marked *