Page 201 - DMGT521_PROJECT_MANAGEMENT

Project Management

Notes We need to determine the average cost for financing the marginal project.
 60000   40000 
Average cost  0.1  0.14  0.116  11.6%
   
 100000   100000 
Since the average cost of the project is below that of the IRR, the project should be chosen.
3. Risk adjustment: So far, we have assumed that all the projects have the same level of risk.
However, this is not true in the real world. In a later unit, we will discuss the technique for
adjusting for different risk level among the projects by adjusting the cost of capital. We can
also adjust for the risk level by adjusting the IOS schedule (i.e. the IRR of the projects).
Projects with above average risk will have a certain percentage points deducted from their
IRRs while projects with below average risk will have a certain percentage point added to
their IRRs.

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Caution In order to pick the right project, the firm needs to find the NPVs of the mutually
exclusive projects.

Self Assessment

Fill in the blanks:
5. A ………………… will continue to accept project as long as the marginal return generated
by the project is higher than the marginal cost the firm needs to pay to finance it.
6. The intersection point indicates the ………………… cost of capital faced by the firm.
7. The marginal cost of ………………… a firm faced depends on the availability of projects.

8. The concept behind the ………………… is very similar to that of the MCC schedule.
9. The ………………… schedule represents the cost of capital faced by the firm.
10. A firm is interested more in maximizing its value, and this can only be done by choosing
the project with the highest ………………… rather than the highest IRR.
11.7 Capital Rationing

Our discussion so far has assumed that the firm invests in projects with IRR greater than its cost
of capital. This implicitly assumes that the firm does not have an investment budget. In other
words, it has an infinite amount of money to invest. However, in many situations, a firm will set
a certain amount for its investment budget that is insufficient to undertake all the available
profitable projects. This is known as capital rationing.
There are many reasons why there is capital rationing:
1. A firm is unwilling to use external funding (i.e. debt and common stock) and rely solely
on retained earnings. This is because the managers feel that using debt makes the firm
riskier and using common stocks dilute their controlling power.

2. A firm might have a shortage of resources such that additional projects would not be
properly managed.
3. A firm limits the investment budget to control the expansion rate so that it will not be
over-extended.

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