Capital rationing and the net present-value (NPV) decision rule The Supergraph/Mastergraph example in Chapter 13 illustrates the difficulty of choosing between mutually exclusive projects that require investments of very different magnitudes, under capital rationing. The choice of a project will affect funds available for other projects, and this effect must be carefully considered. As in the example, the larger project maybe preferred even if its excess present-value index is lower. This occurs when the return on the large project’s funds is sufficiently higher than the return on alternative uses of the extra funds that would be available if the smaller projects were chosen instead. Payback method The Supergraph/Mastergraph example in Chapter 13 shows that the payback method does not necessarily maximise profits, because it is silent about project profitability. However, companies often use payback in conjunction with DCF analyses and select those positive NPV projects that also have an acceptable payback period. Management is most likely to emphasise payback period when the future is very uncertain (and they do not want to tie up cash for long) and when interest rates are high (making it expensive to tie up cash for long periods of time. The major deficiencies of the payback calculation are that (1) it does not necessarily lead to profit maximisation and (2) it discourages selection of long-term projects (e.g. major RD or automation projects may have along payback period, but nevertheless maybe critical to a company’s long-term survival. Too much focus on payback can contribute to short-term myopia
