COMPLICATIONS IN CAPITAL BUDGETING: CAPITAL RATIONING AND

MUTUALLY EXCLUSIVE PROJECTS

Capital rationing the placing of a limit by the firm on the dollar size of the
capital budget.

The use of our capital-budgeting decision rules implies that the size of the capital
budget is determined by the availability of acceptable investment proposals.
However, a firm may place a limit on the dollar size of the capital budget. This
situation is called capital rationing.
In the past, we have proposed that all projects with a positive NPV, a profitability
index (PI) greater than 1.0 or internal rate of return (IRR) greater than the
required rate of return be accepted, assuming there is no capital rationing.
However, this acceptance is not always possible. In some cases, when the two
projects are judged acceptable by the discounted cash flow criteria, it may be
necessary to select one of them, as they are mutually exclusive.
Mutually exclusive projects occurs when a set of investment proposal perform
essentially the same task; acceptance of one will necessarily mean rejection of
the others. For example, a company considering the installation of a computer
system may evaluate three or four systems, all of which may have positive NPVs,
however, the acceptance of one system will automatically mean rejection of the
others. In general, to deal with mutually exclusive projects, we will simply rank
them by means of the discounted cash flow criteria and select the project with
the highest ranking. On occasion, however, problems of conflicting ranking may
arise.
Problems in project ranking
There are 3 general types of ranking problems:
1. Size disparity problem
2. Time disparity problem
3. Unequal life problem
Size disparity problem
- Occurs when mutually exclusive projects of unequal size are examined.
For example:
Year

0
1
NPV
PI

Cash Flows (10%

req.return)
PROJECT A PROJECT B
-200
-1500
300
1900
$72.70
1.36

$227.10
1.15

IRR
-

50%

27%

In this case, if NPV criterion is used, project B should be accepted,

whereas if the PI or IRR criterion is used, project A should be chosen.
So? Which project is better? The answer depends on whether the
capital rationing exists.
Without capital rationing, project B is better because it provides the
largest increase in shareholders wealth, that is, it has a larger NPV.
If there is a capital constraint, the problem then focuses what can be
done with the additional $1300 that if freed if project A is chosen
(costing $200 as opposed to $1500). If the firm can earn more on
project A plus the project financed with additional $1300 freed up if
project A as opposed to project B is chosen, then project A and the
marginal project should be accepted.

Time disparity problem

- Result from the differing reinvestment assumptions made by the NPV
and IRR criteria. For example:
Year

0
1
2
3
NPV
PI
IRR
-

Cash Flows (10% req.

return)
PROJECT A PROJECT B
-1000
-1000
100
650
200
650
2000
650
$758.10
1.758
35%

$616.55
1.617
43%

In this case, NPV and PI indicate that project A is the better of two,
whereas the IRR indicates that project B is the better.
Project B receives its cash flows earlier than project A, and different
assumptions made as how these flow can be reinvested result in
different in rankings. Which criterion should be followed depends on
which reinvestment assumption is used.
The NPV criterion is preferred in this case because it makes the most
acceptable assumption for the wealth-maximizing firm.

Unequal life problem

- Occurs when mutually exclusive projects with different life spans are
examined. For example:
Year

0
1
2

Cash Flows (10% req.

return)
PROJECT A PROJECT B
-1000
-1000
500
300
500
300

3
4
5
6

500

300
300
300
300

NPV
PI
IRR

$243.50
1.2435
23%

$306.50
1.306
20%

In this case, NPV and PI criteria indicate that project B is the better
project, whereas the IRR favors project A. This ranking inconsistency is
caused by the different life spans of the projects being compared. In
this case, the decision is a difficult one because the projects are not
comparable.
There are two methods to deal with this situation which are:
o Replacement chain
Using a replacement chain, the present example would call
for the criterion of a two-chain cycle for project A, that is
we assume that project A can be replaced with a similar
investment at the end of three years. Thus, project A
would be viewed as two A projects occurring back to back
as illustrated in figure below:

$500

$500

-$1000

New
NPV

-1000

$500

$500

Re-invest

500
+

1.11

$500

-$1000

500
=

$500

+
1.12

50
0
1.13

500
+

+
1.14

50
0
1.1
5

500
+
1.16

$426.
32

Or
New NPV
[1,000(PVIF10%,3)]

= -1,000 + [500(PVIFA10%,6)]
= -1,000 + [500(4.355)] [1,000(0.751)]
= $426.50

The new NPV for this replacement chain is $426.32, which

can be compared with project Bs NPV ($306.50).
Therefore, project A should be accepted because the NPV

for its replacement chain is greater than the NPV of project

B.
o

Equivalent Annual Annuity (EAA)

A projects EAA is simply an annuity cash flow that yields
the same present value as the projects NPV. This can be
done in two steps as follow:
Step 1: calculate NPV for both projects. Based on
the figure above, NPV for project A is $243.50,
whereas project B had an NPV of $306.50.
Step 2: calculate EAA for both project by using this
formula.
Equivalent Annual Annuity (EAA) = NPV / PVIFA

I,n

Project A= $243.50/(PVIFA10%,3)
= $243.50/2.487
= $97.91
Project B= $306.50/(PVIFA10%,6)
= $243.50/4.355
= $70.38

Therefore, project A should be accepted because of higher

EAA.
From here we can calculate infinite-life replacement chain
by simply dividing the EAA by the appropriate discount
rate. In this case, we find:
NPV,A
NPV,B

=
=
=
=

$97.91/0.10
$979.10
$70.38/0.10
$703.80

EXAMPLE:
The Battling Bishop Corporation is considering two mutually exclusive pieces of
machinery that perform the same task. The two alternatives available provide the
following set of after-tax net cash flows:
Year
0
1
2
3
4
5
6
7
8
9
NPV

Equipment
A
-$20,000
13,000
13,000
13,000

Equipment
B
-$20,000
6,500
6,500
6,500
6,500
6,500
6,500
6,500
6,500
6,500

$10,186

$12,149

Equipment A has an expected life of 3 years, whereas equipment B has an

expected life of 9 years. Assume a required rate of return of 14%. Compare these
projects using replacement chain and EAAs. Which project should be selected?
Support your recommendation.
Solution:
Using 3 replacement chains, project As cash flows would become:
Year
0
1
2
3

4
5

(20,000+13,00
0)

Cash
Flow
-$20,000
13,000
13,000
-7,000

13,000
13,000

7
8
9

(20,000+13,00
0)

-7000

13,000
13,000
13,000

New NPV = -20,000 + [13,000(PVIFA14%,9)]

[20,000(PVIF14%,6)]
=
-20,000
+
[13,000(4.946)]
[20,000(0.456)]
= $21,678

[20,000(PVIF14%,3)]

[20,000(0.675)]

The replacement chain analysis indicates that project A should be selected

as the replacement chain associated with it has a larger NPV ($21,678)
than project B (NPV=$12,149)
Equivalent Annual Annuity
o Project As EAA
Step 1
: NPV
= $10,186
Step 2
: calculate the EAA
EAAA
= NPV/ PVIFA14%,3
= 10,186/2.322
= $4,387
o Project Bs EAA
Step 1
: NPV
= $12,149
Step 2
: calculate the EAA
EAAA
= NPV/ PVIFA14%,9
= 12,149/4.946
= $2,256
Project B should be selected because it has a higher EAA.