1.25 Capital Budgeting and the Limits of a Firm’s Capital 

With regard to the “The Capital Rationing Problem” we considered the fact that the firm had limited capital resources upon which to call. Here, we revisit the issue given the theoretical possibility that the firm has unlimited (or virtually unlimited) resources and, if so, how that fact would impact, if at all, the Capital Rationing Problem? You will find that it is not merely a theoretical matter.

Question:

If a firm has numerous projects all of which exceed the acceptance criteria under either NPV, IRR, or MIRR (this last concept will come up later), why choose only that which is best under the relevant, or chosen, criterion, assuming mutual exclusivity? (Let’s assume there are no physical limitations.) If the firm has abundant access to the public capital markets (even if limited), both bond and stock markets, why not take on and finance all acceptable projects, if need be, with external funds? (In effect, there would be no mutual exclusivity were there no physical or financial limitations!)

Answers:

Is this question realistic? Perhaps so, within reasonable but extensive limits. Too much debt negatively impacts solvency. So.. why not use a combination of debt and equity, so their solvency is not potentially threatened? Firms are reluctant to issue new equity:

• Some investors may see this as a negative “signal” to the market that the firm is not doing well, or that the stock is over-valued. This could cause the stock price to decline.
• More equity could dilute management’s ownership stake and control. And EPS may be reduced.
• If they accept projects with low rates of return, i.e., lower than their investors’ opportunity costs, investors may not put up any capital!

Internal analysts who recommend investments may have a personal bias. One can get emotionally attached to an idea. One may wish to take a chance on the aspiration that he will look good and thereby enhance his/her career. Forecasts may be too optimistic. Managers know this. By investing in optimal selections, management imposes discipline in the capital budgeting process.