Capital rationing• Enormity of funds requirements• Limited availability of funds• Capital rationing resorted to by firms who are not able to generate additional funds• Ceiling is set on capital spending—consider only projects with high NPVs
Why capital rationing?• External reasons—occurs when firm has many options for investment but is unable to take them up either becoz of insufficient funds or becoz capital markets are not favourable – Lack of standing in the market—cannot raise funds due to the credibility issues – High floatation costs
Why capital rationing?• Internal reasons—occurs when the firm has self imposed restrictions on funds allocated for fresh investments• Availability of funds or have the ability to procure funds from markets, but they do not do so—use retained earnings to foster growth—implies firms do not want to grow
Steps in capital rationing• Ranking of different investment proposals• Selection of most profitable proposal based on the ranks or highest NPVs
Risk analysis• Risk refers to the uncertain conditions under which a firm performs• Exist becoz of the inability to forecast future situations• Forecasts not done with precision
What is Risk Management?• Risk Management is the logical and systematic method of identifying, analysing, treating and monitoring the risks involved in any activity or process.
Events affecting investment forecasts• 3 categories – General economic conditions—political changes, monetary policies, taxation policies, lending conditions, social conditions – Industry factors—spurt in employment and construction industry – Company factors—change in management, strike or lock out
Types of risks• Project specific risk—wrong estimates, considering high discount rates, wrong estimates about material and labour• Competition risk—actions of competitors, price wars• Industry specific risk—changes in technology, changes in laws like change in service tax rates, bringing in new services into the net• International risk—increase/decrease in foreign currency, political connections• Market risk—inflation, general economic conditions, change in bank lending rates
Techniques of incorporation of risk factor in capital budgeting decisions• Conventional techniques – Payback method – Risk adjusted discount rate – Certainty equivalents – Sensitivity analysis• Statistical techniques – Probability distribution approach – Decision tree approach
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