10: Cash Flow and Capital Budgetinginvestments are not generating acceptable levels of cash flow. Perhaps investors may see the decision to
issue new shares as an indication that managers believe the company’s shares are overvalued. In either
case, investors may react negatively to this announcement, causing the share price to fall. Undoubtedly,
managers try to persuade investors that the funds being raised will be invested in profitable projects, but
convincing investors that this is the true motive for the issue is an uphill struggle.
A second reason why managers may avoid issuing new equity is that by doing so, they dilute their
ownership stake in the company (unless they participate in the offering by purchasing some of the new
shares). A smaller ownership stake means that managers control a shrinking block of votes, raising the
potential of a corporate takeover or other threat to their control of the company.
In conversations with senior executives, we often hear a third reason why companies do not fund every
investment project that looks promising. Behind every idea for a new investment is a person, someone who
may have an emotional attachment to the idea, or a career-building motivation for proposing the idea in the first
place. Upper-level managers are wise to be a little sceptical of the cash flow forecasts they see on projects with
favourable NPVs or IRRs. It is a given that every cash flow forecast will prove to be wrong. If the forecasting
process is unbiased, forecasts half the time will be too pessimistic, and half the time be too optimistic. Which half
is likely to surface on the radar screen of a CFO or CEO in a large corporation? (Answer: the optimistic ones.)
Establishing an annual budget constraint on capital expenditures to ration capital is one mechanism by which
senior managers impose discipline on the capital budgeting process. By doing so, they hope to weed out some of
the investment proposals with an optimistic bias built into the cash flow projections.
Selecting the Best Projects Under rationing
Regardless of their motivation, managers cannot always invest in every project that offers a positive
NPV. In such an environment, capital rationing occurs. Given a set of attractive investment opportunities,
managers must choose the combination of projects that maximises shareholder wealth, subject to the
constraint of limited funds. The following example demonstrates the application of this approach for
selecting investments under capital rationing.
exampleAssume that a particular company has five projects
to choose from, as shown in Table 10.5. Note that all
of the projects require an initial cash outflow in year
0 that is followed by four years of cash inflows. All of
the projects have positive NPVs, IRRs that exceed the
company’s 12% required return, and PIs greater than
1.0. Notice that the first project has the highest IRR
and the highest PI, but project 5 has the largest NPV.
This is again the familiar scale problem discussed in
Chapter 9. Suppose that this company can invest no
more than $300 million this year. What portfolio of
investments maximises shareholder wealth?
Notice that there are several combinations of
projects that satisfy the constraint of investing no
more than $300 million. If we begin by accepting
the project with the highest PI, then continue to
accept additional projects until we bump into the
$300 million capital constraint, we will invest in
projects 1, 2 and 3. With these three projects, we
have invested just $250 million, but that does not
leave us with enough capital to fund either project
4 or 5. The total NPV obtainable from the first three
projects is $170.8 ($59.2 + $52.0 + $59.6) million.
No other combination of projects that satisfies the
capital constraint yields a higher aggregate NPV.
For example, investing in projects 3 and 5, thereby
using up the full allotment of $300 million in capital,
generates a total NPV of just $130.6 ($59.6 + $71.0)
million. Likewise, investing in projects 1, 2 and 4,
another combination that utilises all $300 million
in capital, generates an aggregate NPV of $149.6
($59.2 + $52.0 + $38.4) million.^11capital rationing
The situation where a
company has more positive-
NPV projects than its available
budget can fund. It should
choose the combination of
those projects that maximises
shareholder wealth11 Reviewing Table 10.5, we see that the IRR and PI result in identical project rankings. Therefore, had we used the IRR rather than the PI, we would
have selected the same set of projects. These two decision techniques generally result in similar, but not necessarily identical, project rankings.