1. Chapter 22 -- Capital Rationing
Capital Market imposed capital rationing
Intersects the cost of capital line at a vertical point due to information asymmetry
Investors simply may not be willing to provide more money to the company because they do not believe more growth is good
We intersperse end-of-chapter problems with PowerPoints to execute our teaching strategy for a particular group of students.

2. Reasons for Capital Rationing
Management policy
Common practice – 72% of companies
Tool for allocating funds in support of strategy
Control problems if more securities are sold
Limit risk by limiting growth

3. Reasons for Capital Rationing
Management policy (continued)
Belief that competition forces the best projects to the top of the heap
Uncertainty about the actual cost of capital
Surrogate for dealing with other scarce resources, such as management talent

4. Capital Rationing and NPV
Use the rate over the constrained period and then the cost of capital
When NPV conflicts with IRR use the NPV method

5. Single-period Capital Rationing
No capital rationing expected after this year’s selections are made
Wealth maximization rule is to allocate scarce capital so as to maximize total NPV using the standard NPV evaluation methods

6. Multi-period Capital Rationing
Allocate capital so as to maximize wealth as of the end of the capital rationing period (TWc)
c n TWc = CFt(1+Rt)c-t + CFt/(1+k)t-c – I0(1+R0)t t= t=c+1 Where c is the number of periods of capital rationing, CFt is cash flow in period t, Rt is the reinvestment opportunity rate for period t, k is the required return (WACC), and I0 is the initial investment.

7. Multiperiod Capital Rationing
If capital rationing will last as long as proposed investments, cost of capital will remain constant, and reinvestment opportunity rate will remain constant, NPV with capital rationing (NPVR) =
n NPVR = CFt/(1+R)t – I t=1 Where R is the reinvestment opportunity rate

8. IRR Rankings in Capital Rationing
IRR ranking will lead to correct selection if capital rationing will last as long as the proposed investment, R will be the same each period, and will exceed the cost of capital, and R is the rate of return on the highest rejected investment.
Multiple IRRs
Dorfman shows that if the project has more than one IRR, the highest IRR is the rate at which capital will grow

9. Profitability Index and Capitial Rationing
Useful only for single-period rationing

10. Mutually Exclusive Projects and Capital Rationing
General solution requires mathematical programming
If the company has enough capital this period to accept all investments above the internal reinvestment rate, R, the problem can be simplified to maximizing NPV using R as the discount rate