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Optimizing Capital Budget: Unequal Lives & Capital Rationing

Learn how to evaluate projects with unequal lives using techniques like Replacement Chains and Equivalent Annual Annuities. Understand the impact of increasing marginal cost of capital and capital rationing on financial decision-making.

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Optimizing Capital Budget: Unequal Lives & Capital Rationing

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  1. Video 37 (Topic 7.3):Other Issues FIN 614: Financial Management Larry Schrenk, Instructor

  2. Topics • Projects with Unequal Lives • Replacement Chains • Equivalent Annual Annuities (EAA) • Final Thoughts

  3. Evaluating Projects with Unequal Lives • If two projects have unequal time horizons, we need to make adjustment before computing NPV. • (Equivalent) Solutions • Replacement Chains • Equivalent Annual Annuities (EAA)

  4. Uneven Lives Example▪ • Consider these two mutually exclusive projects (r = 10%): • NPVA = $413.22 and NPVB $568.27 • Is B the better project? • What about the return on our funds in years 3 and 4, if we accept Project A?

  5. Replacement Chains • Evaluate each project over an equal time horizon. • Compare NPV and IRR over extended periods.

  6. Replacement Chain Example • Evaluate each project over an equal time horizon. • Repeat Project A, so that it covers the same time horizon as Project B (r = 10%). • Recalculate NPV*A over 4 years horizon. • NPV*A = $754.73 > NPVB $568.27→ Project A

  7. Equivalent Annual Annuities (EAA) Approach • Find NPV for each project. • Convert these NPV’s into equivalent annual annuity payments. • Select the project with the higher equivalent annual annuity payments

  8. EAA Example • NPVA= $413.22 and NPVB $568.27 • EEAA N = 2; I% = 10; PV = -413.22; PMT = ???; FV = 0 PMT (EEA) = $238.09 • EEAB N = 4; I% = 10; PV = -568.27; PMT = ???; FV = 0 PMT (EEA) = $179.27 • EEAA > EEAB → Project A

  9. Choosing the Optimal Capital Budget • Finance theory says to accept all positive NPV projects. • Two problems if not enough internally cash to fund all these projects: • Increasing Marginal Cost of Capital • Capital Rationing

  10. Increasing Marginal Cost of Capital • Flotation costs with externally raised capital increases the cost of capital • Large capital projects seen as risky, which drives up the cost of capital • If external funds needed, then the NPV should be estimated using this higher marginal cost of capital

  11. Capital Rationing • Capital Rationing: Company cannot fund all positive NPV projects • Possible Reasons: • Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. • Companies don’t have enough staff to implement all positive NPV projects.

  12. Video 37 (Topic 7.3):Other Issues FIN 614: Financial Management Larry Schrenk, Instructor

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