Optimal Capital Budget
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Choosing the Optimal Capital Budget Finance theory says to accept all positive NPV projects. Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:
Increasing Marginal Cost of Capital
Externally raised capital can have large flotation costs, which increase the cost of capital. Investors often perceive large capital budgets as being risky, which drives up the cost of capital.
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An increasing marginal cost of capital. Capital rationing
Copyright © 1999 by The Dryden Press All rights reserved.
Copyright © 1999 by The Dryden Press
All rights reserved.
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Capital Rationing If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital. Capital rationing occurs when a company chooses not to fund all positive NPV projects. The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.
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Copyright © 1999 by The Dryden Press All rights reserved. Copyright © 1999 by The Dryden Press All rights reserved.
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Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital.
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Copyright © 1999 by The Dryden Press All rights reserved.
Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing.
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Copyright © 1999 by The Dryden Press All rights reserved.
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Blum Industries has 5 potential projects:
We’ve seen how to evaluate projects. We need cost of capital for
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Choosing the Optimal Capital Budget Finance theory says to accept all positive NPV projects. Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:
Increasing Marginal Cost of Capital
Externally raised capital can have large flotation costs, which increase the cost of capital. Investors often perceive large capital budgets as being risky, which drives up the cost of capital.
(More...)
An increasing marginal cost of capital. Capital rationing
Copyright © 1999 by The Dryden Press All rights reserved.
Copyright © 1999 by The Dryden Press
All rights reserved.
11 - 3
11 - 4
Capital Rationing If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital. Capital rationing occurs when a company chooses not to fund all positive NPV projects. The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.
(More...)
Copyright © 1999 by The Dryden Press All rights reserved. Copyright © 1999 by The Dryden Press All rights reserved.
11 - 5
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Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital.
(More...)
Copyright © 1999 by The Dryden Press All rights reserved.
Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing.
(More...)
Copyright © 1999 by The Dryden Press All rights reserved.
1
11 - 7
11 - 8
Blum Industries has 5 potential projects:
We’ve seen how to evaluate projects. We need cost of capital for